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.

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).

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.

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.