What is sequence of return risk?
Otherwise known as sequence risk, it is a risk associated with the order in which your investment returns occur during your retirement. It can potentially have a substantial impact when you are periodically taking distributions from your investments, reducing the longevity of your retirement capital (increasing the chances you run out of savings prior to life expectancy).
One way to mitigate sequence of return risk for a retiree is by altering portfolio security selection to include some maturity-matched securities in correlation with the retiree’s cash flow needs. This strategy can be implemented using bond ladder ETFs (exchange-traded funds). A bond ladder ETF is a diversified portfolio of individual bonds with similar maturity dates. Each ETF delivers periodic interest payments (typically monthly) and then distributes a final payout in the stated year of maturity. This structure is like that of traditional bond laddering, except the unique structure of the funds is designed to help an advisor and investor easily build bond ladders with a limited number of securities.
Bond ladder ETFs are designed primarily to deliver the following:
– Mature like a bond (pay out their net asset value in their maturity year)
– Trade like a stock (the ETFs can be bought and sold like shares of equities during any given trading day)
– Diversify like a fund (the ETFs hold several hundred bonds from different regions and within different industries)
– Match expected cash flows (offering a defined maturity date can help an investor have cash on hand when an expense comes due)
When you can match an asset in your portfolio (bond ladder ETF) with an anticipated liability (cash flow requirement
annually) in your retirement it helps to eliminate the overall impact of short term volatility within global equity markets as well as changes in interest rates, ultimately reducing the impact of sequence of return risk.
The Waterford Way
Every one of our clients that has entered the “distribution phase” of their lives (retirement), has a detailed year-over-year Retirement Cash Flow plan that is personalized to their own long-term goals and objectives. One of the many benefits of having a detailed cash flow model for your retirement is knowing, years in advance, what your likely cash flow needs will be for a specific year of retirement and designing the portfolio mix in advance to adhere to those anticipated cash flow needs.
Depending on the asset allocation model that is most appropriate for you and achieving your long-term goals, a multi-year bond ladder ETF strategy is implemented within the fixed income design of the household portfolios to match your spending requirements. This allows us as the advisor the flexibility
to evaluate annually when re-balancing is being performed, to choose how the following year’s cash flow needs for an individual client will be filled; a maturing bond ladder or trimming excess equity gains from an outperformance year (theoretically allowing you to always consume an appreciated asset). Most of our retired clients have a bond ladder ETF strategy in their portfolios for a period that is equivalent to the average duration of a “bear market”. This allows peace of mind to the client that they could consume maturing bond ladders exclusively for several years, allowing ample time for their equity positions to recover from short-term depressed prices.
Portfolio design in retirement should take a different approach than portfolio design while still accumulating. There are risks that are unique to retirement vs. when you are still a “saver” and for that reason you will need to identify ways to mitigate these risks as the primary objective of your portfolio becomes income generation rather than long-term growth. If you want to learn more about retirement cash flow planning and portfolio design for a retiree, or simply check in on your own plan that is currently in place, feel free to contact a member of our team.