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An Untimely Retirement: The Dangers of 'Sequence Risk' for Retirees

Introducing PIMCO’s “Income to Outcome” retirement framework.

When the stock market swooned this summer, many investors were understandably unsettled. But for individuals on the cusp of retirement, the downturn also echoed eerily from the past.

The S&P’s recent dive came several days after the Federal Reserve cut interest rates on 31 July. It was nearly 12 years earlier that the Fed began its last rate-cutting cycle (see Figure 1). The 2007 cut presaged a deep recession and stock market rout that wiped out nearly half the value of the S&P 500 by March of 2009. Many retirees saw their wealth, and future retirement income, permanently impaired.

Figure 1 shows a graph of the federal funds rate. The rate starts in 2007 at around 5.25%, then drops sharply with series of cuts starting in September that year, down to 0.25% by late 2008. Rates were kept between 0% and 0.25% until 2015, when the Fed resumed raising rates, which climbed to 2.5% by late 2018. The Fed cut rates again to 2.25% in August 2019. A grey shaded area on the left of the graph marks a recession, in the 2007 to early 2009 period.

PIMCO doesn’t expect history to repeat itself, but it may rhyme. (Our recent Secular Outlook, “Dealing With Disruption,” explains our baseline forecast of lackluster but continued global growth.)

Either way, the market malaise a decade ago provides lessons for structuring retirement portfolios today. These are embedded in our new Income to Outcome retirement framework, which aims to help retirees better manage the first leg of their retirement journey, and beyond.

The impact of withdrawals

Market meltdowns are always unsettling. But for a portfolio that is not supporting withdrawals, a rough starting period may not be an issue – the sequence of returns won’t affect its ultimate annualized rate of return. Whether returns start out strongly positive or negative, the portfolio will end up at the same spot for a given series of returns. But for those entering retirement, the sequence of the market’s returns can be downright devastating, particularly if they start out on the wrong foot. The reason is withdrawals and their impact on future growth.

Indeed, a major market downturn at the beginning of one’s retirement journey is among the most potentially destructive scenarios for investors. At the start, the impact can appear punishing in its own right. But the more painful consequences often come many years later, as the portfolio struggles to regain lost ground and its longevity declines faster than the retiree’s own.

Consider an investor with a hypothetical $1 million portfolio invested 60% in stocks and 40% in bonds on 31 July 2007.i, ii Despite a 51% drop in the stock market from October 2007 to March 2009, the portfolio would have recovered fully by 2011, just two years later – but only if the investor had the means and foresight to leave it untouched. By keeping hands off until July 2017, the balance would have grown to nearly $2 million.

But if the same hypothetical investor, retiring on the same date, had instead withdrawn $50,000 annually to meet daily expenses, the outcome would have been far different. The impact of the global financial crisis right out of the gate would have severely undermined the portfolio’s long-term growth potential. Even today, 12 years later, the portfolio would have climbed back to only $1.2 million, despite the almost 300% cumulative return in the S&P 500 Index since then (see the green line in Figure 2).

Figure 2 shows a graph of the market value over 12 years of two identical portfolios invested 60% in stocks (proxied by S&P 500) and 40% in bonds (proxied by Bloomberg Barclays US Aggregate Index), and each portfolio starting with $1 million. The one with an untimely start in July 2007 grows in 12 years to roughly $1.2 million, while the other one having a timely start in March 2009 grows to nearly $1.7 million.

Compare this untimely retirement with a more “timely” variant – a retiree who experienced the same returns but in slightly different order. Let’s assume the retiree first experiences the “good 10 years” corresponding to the July 2009 to July 2019 period and then is hit by the “bad two years” corresponding to the July 2007 to March 2009 period. The trajectory (shown by the blue line in Figure 2) is vastly different, with the portfolio growing to nearly $2.5 million before dropping back to just under $1.7 million after the ”bad two years” (corresponding to the recession and market collapse from 2008–2009). In the end, the two distinct sequences of returns lead to a difference of more than $460,000 in wealth (almost half of the initial $1 million hypothetical portfolio value) at the end of the 12-year horizon.

Behavioral factors

An even bigger risk associated with a downturn early in retirement is behavioral: Downturns can be alarming, making it difficult for an investor to stay the course and rebalance back to their target allocation, or mix of stocks and bonds.

Figure 3 illustrates how behavioral pitfalls in the wake of a major downturn can undermine long-term portfolio growth. The purple line tracks the value of the portfolio of a hypothetical investor who overreacts to the 2007–2009 market shocks in typical fashion, de-risking their portfolio to emphasize bonds (60%) instead of stocks (40%). Some investors may even seek a presumed “safe haven” and run entirely to cash in an effort to hide from further market erosion, only returning to their long-term plan years later after markets have recovered (the green line). Both paths tend to crystallize the original loss and dig a deeper hole, making recovery harder or even impossible. These behavioral tendencies can have drastic negative wealth implications. As such, we believe it is paramount to develop a decumulation framework that seeks to help retirees avoid such pitfalls.

Figure 3 shows three scenarios of a portfolio with $1 million in 2007, with an allocation of 60% to stocks and 40% to bonds (same proxies as Figure 2). One line on a graph shows that if an investor stayed the course and rode out the crash, the portfolio would have been worth $1.21 million in 2019. Another line shows that if the investor switched the allocation to 40% stocks and 60% bonds at the market bottom in 2009, the balance would have been around $919,000 in 2019. A third line sloping downwards shows that if the investor moved to all cash at the market bottom in 2009 and stayed there, the portfolio would have ended with a value of $306,000 in 2019.

Income to Outcome: a retirement framework to help mitigate sequence risk

The latest bout of volatility provides a salient reminder to the baby boomers heading into retirement – 10,000 a day and rising. While we’re not alarmist, equity valuations remain near historical highs and the U.S. economic expansion has reached an unprecedented length.

Fortunately, investors are not completely at the mercy of the markets when it comes to sequence risk and retirement.

One way to help mitigate the threat could be to prefund the desired level of income replacement in retirement for a certain number of years. This could be accomplished with a dedicated bond portfolio whose cash flows (coupons and principal payments) are expected to match the retiree’s income needs. For example, target-maturity bonds (also known as defined-maturity bonds) are designed to mature and pay out principal (minus defaults) after a specific number of years. (Low-volatility income-oriented fixed income strategies could also be used to approximate a similar outcome.) This portfolio could serve as a sort of “paycheck replacement.”iii

Bond allocations of this sort also are flexible, and therefore allow for adjustments over time as retirees’ conditions and circumstances change – unlike contractual insurance-type products such as immediate or deferred income annuities. Investors remain in control and can make adjustments at their discretion.

At the same time, assets not allocated to the bond portfolio can be allocated to equities and other growth-oriented investments to help retirees maintain and grow their wealth in retirement, despite the need to fund daily expenses. Crucially, a predictable stream of income from a dedicated bond portfolio means retirees may be less likely to need to tap their growth-oriented investments to fund expenses. This should help investors ride out the up and downs typical of higher-risk, higher-return assets – and, in the process, help to mitigate the effects of sequence risk. The two portfolios – one designed for income, the other for longer-term growth – represent a fine balance that our new framework seeks to solve: predictable income and growth on one hand; flexibility and control on the other.

The framework’s creation of two portfolios is a key differentiator. On the surface, it’s an approach similar in some ways to a traditional blend of stocks and bonds, and which would be similarly exposed to sequence risk.

But with an anticipated stream of income from the bond portfolio, the investor may be more likely to ignore the natural, and sometimes violent, volatility that often accompanies growth-oriented investments. This, in turn, may help investors avoid costly, knee-jerk reactions when their growth portfolio slumps or soars, thus mitigating the impact of sequence risk.

It’s human nature to want things that often conflict – in this case, the desire for predictable income and the potential for growth. And therein lies the objective of the Income to Outcome framework. It addresses both the hard issues of asset allocation and the softer, but no less significant, challenges of behavioral finance.

For more on our new Income to Outcome retirement framework, click here.

i Stocks are represented by the S&P 500 Index
ii Bonds are represented by the Bloomberg Barclays US Aggregate Index
iii Investment products contain risk and may lose value. There is no guarantee that an investment product will be successful in producing income. Investors should consult their investment professional prior to making an investment decision.
The Author

Rene Martel

Head of Retirement

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A bond ladder or “targeted maturity” bond portfolio is only one potential income strategy and may not be the best solution or suitable for all investors. Income replacement needs may vary by household. An investor should consider and discuss how best to address their income needs with their financial and tax professionals.

The retirement allocation framework presented here is based on what PIMCO believes to be generally accepted investment theory. It is for illustrative purposes only and may not be suitable for all investors. The retirement allocation framework is not based on any particularized financial situation, or need, and is not intended to be, and should not be construed as, a forecast, research, investment advice or a recommendation for any specific PIMCO or other strategy, product or service. Individuals should consult with their own financial and tax advisors to determine the most appropriate allocations for their financial and tax situation, including their investment objectives, time frame, risk tolerance, savings and other investments. Fixed income is only one possible portion of an investor’s portfolio, which can also include equities and other products. Investors should speak to their financial advisors regarding the investment mix that may be right for them based on their financial situation and investment objectives.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counter party capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.

Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

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