>> Matt Nelson: What would you say if I told you two investors could have the same investment portfolio over the same time frame with the same fees and end up with a different amount of money if you're within five to seven years of retirement? This is a very important concept you need to understand before it's too late. Welcome back to the show, everyone. I'm, um, Matt Nelson and I've been helping people retire for over 25 years. We look at what works and what doesn't. Retirement planning and tax, tax strategy and more. Now, today we're going to talk about something called sequence of returns risk. This is one of the most important concepts you need to understand as you're coming into what we think about as the retirement launch zone. That's about five to seven years before you actually turn in your papers. Retire, have no more regular income. Now it also includes a period of probably five to seven years on the other side of retiring as well. The reason that these two time frames are so important is because when you see negative returns in a portfolio, and you will at some point in your investment career, it really matters when they come in. Do they come in at the end of an accumulation period or do they come at the beginning of a withdrawal period? So we're going to look at this concept. I'm going to first start off with, um, an illustration from BlackRock. And we get a lot of very good concept material from them for explaining things like this to our clients. And they have a piece called Sequence of Returns here. What we're going to look at is they're illustrating three separate portfolios and they've taken a simplified approach to just take five years worth of returns and then they're going to repeat that return pattern, uh, on from age 40 to 65. So in portfolio A, what's being illustrated here is that this portfolio has a positive return of 22% followed by 15, 12, and then a negative 4 and 7 results in A, in a positive 7% average rate of return for that period. Now that portfolio A is going to just repeat that pattern. It's represented in the red or the orange here, uh, over this time horizon. And $1 million is, is going to grow to about $5.4 million. Now contrast that with portfolio C, where simply the returns have been reversed. So negative 7, 4, 12, 15, 22, just the opposite of portfolio A. And you can see what happens here. Starting value actually drops a bit before it begins to recover, drops again. Portfolio B is just an average of 7% every year. So steady state. Now, with an investor that's in the accumulation phase, it really doesn't matter if you start at age 40, end at age 65, doesn't matter what return pattern you have, you're going to end up with the same amount of money. It's just going to take a little bit of a different path to get there. But the big problem happens when we get into the withdrawal phase. So in this illustration, we're using the same exact portfolios in the return pattern, but now we're actually starting with a million dollars. And then we're going to take out $60,000 a year and adjust that for inflation over time. Now what happens is, because the negative returns come on the front end in portfolio C, the portfolio actually gets behind before you even get going. And it can never really quite catch up. In fact, even the 7% average portfolio eventually starts to give up to the inflation adjustment that you're making to these withdrawals. Portfolio A, because we had such a boost in the beginning, that actually helps to carry, uh, a lot of the portfolio for quite a while. So I hope that helps to kind of start framing the message. Now. I'm going to show you another concept, though, that really, I think, brings this home. Here's what's happening is a lot of times people think about returns and they just want to add them together and make an average. And while that is technically the average, it doesn't speak to the compounding of wealth. So we'll look at this concept. If you have made 50% and then you lose 50% or the other way around, your average return is actually zero. Um, but that doesn't speak to what the dollar value of what you would have would be. So let's look at the concept here. Breaking even. If you have $1 and you lose 50%, you now have 50 cents, you actually have to make a hundred percent. You have to double your money from this point to get back to even. Then this graph really gives us a look into how badly negative returns affect portfolios. Let's say you lost 10% in a year. You actually, the next year would need to make 11 just to get back to even. And when we start to look at some of the bigger declines in the markets, let's just say, uh, the year when we had Covid and there was a decline in the market, or the 2022 decline, or maybe some of the bigger declines, the financial crisis and the tech bubble. When we have those types of declines and your portfolio goes down 40%, you've got a lot of work to do just to get back to where you started. One more illustration here. Just a simple spreadsheet that I made to help look at this with some numbers. And then we're actually going to pop into my financial planning software and show you the real life, um, example on a sample portfolio. So what I created here in this spreadsheet to try to make this, um, more relevant, what I've shown is a million dollar portfolio. We're going to start with both of them the same. No withdrawals, okay? 7% rate of return all the way out for 18 years and then two years of negative 13. So lucky 13 there for two years in a row. On this side in the green investor, we've got the negative 13s in the front end, okay. At the end of the period, they've both averaged 5% a year. So all of these returns are going to average 5%. Portfolio, as you'd expect, ends up the same level. Now when you add in a withdraw of let's say 5%, starting balance. And again, this is very simple, just 50,000 a year, same amount throughout the period. The portfolio that has the negative returns at the end actually has made money over that timeframe. Portfolio, uh, is now worth 1.178. However, on this side where we started off with the negative returns, just two years of negative returns, we've actually are seeing the portfolio down to 540,000. So it's like half of the portfolio that gets the negative returns at the back end. Now to put a point on it, I built another illustration to show that you can actually have a portfolio that is making a higher average rate of return and, and still end up less at the end. So in this situation, what I've done is I've got the same scenario set up negative 13% for two years at the end for investor in blue and in green, we drop that to just one year on the front end at negative 13. Now what that does is the average rates of return are different. Now investor in green is actually gonna average 6% a year. Again, remember that doesn't speak to the compounding of the dollars. And, um, with no withdrawal or no deposit as we'd expect, their portfolio is going to end much higher as soon as we throw that withdraw in 5%. So 50,000 a year, you can actually see that even though their average return was a full percentage higher, the investor in green still ended with a lower portfolio value than the investor in blue. So that's how important it is to be careful of negative years in your portfolio on the very front end of withdrawing. Okay, now let's jump into the planning software and take a look at a sample portfolio, a sample client and see how this really plays out in a little more real world setting. What I have set up here is an investor age 50. They've got a million dollar portfolio. I've named them sequence of returns, their cash flow. I have them set up to be earning about $150,000 a year salary and that's going to continue out inflation adjusted until they retire at age 66. And then they'll start to begin to collect Social Security along the bottom and they'll take portfolio withdrawals out of their investments. The difference between the yellow here is just pre required minimum distribution withdrawals and then the orange level is showing required minimum distributions. But at any rate, I don't have them saving. We're just making this very simple million dollars to start with, no savings. They continue to work and then they start to withdraw it, get retirement. Okay, now how does this look? Everything works out just great. They actually grow the portfolio over time and they've continued to draw down their expenses. However, when we put at the front end we have early negative returns. What I've added in is just two years of negative 13% at the start of their retirement. And so if we look through this column about the annual growth rate, we can see here at age 66, we've got two years there of negative 13% and then we go back to the regular average. So I haven't disrupted this much at all, just two years. What happens though is you'll see we went from everything being just fine with the average rate of return, uh, ending their, their retirement with over $5 million to adding just two years at the beginning of their retirement actually has them running out of money uh, before uh, age 90, uh, 5, right around 91 is when we, we see the portfolio be fully depleted. Now if we compare that to having negative returns a little bit later in their retirement, we'll look at this situation where all I've done is move those two negative years of 13% out to age 76. So just 10 years into their retirement, I add in two negative years of 13% and then I go back to the same average. Now, uh, what does that look like? We actually have a scenario now where there's enough growth still in that first 10 years of retirement. The portfolio certainly takes a hit, but we actually don't see this investor running out of assets. So what can we do to fix this? Well, there's several different ways. I'm just going to go through five briefly the first is as you're entering that, that retirement launch zone that we think of, and you get in within about five to seven years of uh, the time frame when you might actually need to start withdrawing from your portfolio, you need to start raising some of your, your growth investments into shorter term vehicles like cash, treasury bills, CDs, things that won't have much fluctuation at all and it'll be ready for you to spend when it's time. The second item that you can pay attention to is really evaluate, uh, the investment markets as you're approaching retirement. If you're coming into a year, let's just say like 2022, and the markets were very difficult for most investors. If you had planned to retire at the end of 2022 and you were meeting with your advisor or evaluating things on your own, and you saw that the stock markets were having a lot of difficulty that year, if you could delay retirement even six months a year, it makes a tremendous amount of difference. So, uh, thinking about retiring just a little bit later based on what's happening in the markets right before you retire. Another very solid strategy to help deal with sequence returns risk. The third way to deal with this risk is to think like a pension plan. You want to think about having a, uh, portfolio that's liability driven, not just based on your risk tolerance. So what I mean by that is think about the amount of money you're going to need to spend over the next few years. Set that aside in instruments that are available to spend and back into how much you need to have in growth investments. Don't just take some simple risk tolerance questionnaire and let that drive all of your investment decisions. So think like a pension plan. Think about what the portfolio needs to do and let that drive your investment portfolio decisions. I'll give you some examples of how this could work. We've talked about setting aside, let's say five to seven years of your portfolio for spending. So for instance, if you're more comfortable having a large portion of your portfolio in the stock market and the growth investment side, maybe you only set aside five years worth of these spending instruments. Well, five years times let's say a 5% starting amount that you need to take out of the portfolio is 25%. That gives you approximately a 75%, 25% portfolio, 75% growth, 25% income or spending account. You take that a step further. Let's just say you want to be a little more conservative. You're more comfortable having seven years worth of this spending set aside and you're using the same 5% withdrawal rate. Well, 7 times 5 is 35%. That gives you about a 65, 35 portfolio. So this is very connected to reality. But what I want to emphasize is think about your spending need versus your risk tolerance. First, think like a pension plan. Now, number four, we need to think about to mitigate this sequence of returns. Risk is portfolio strategy. And rebalancing does matter. This is where having an active advisor or being active yourself in evaluating what portion of your investments are up this year, maybe we should take profits off of those. Let others run. Don't just blindly rebalance your portfolio and sell something every year to replenish your spending bucket. So, for example, let's say technology stocks have been on a run. They're up significantly compared to the rest of the portfolio. Makes a lot of sense to pull some profits off of those, put them back into the, into the treasury bills or the CD portfolio. If, on the other hand, technology stocks might be down this year, um, maybe your real estate portfolio, maybe the, uh, dividend stocks that you have have been doing a little bit better. That's where we're going to raise cash from. That's a very different process than just simply selling across the board. And the last item is to just be flexible with your spending. So instead of relying on just a rule of thumb, 4% withdrawal rate, and just blindly take out that amount every year, adjusted for inflation, you need to think about a dynamic strategy. Maybe we set a target at the beginning based on your spending need. And if the portfolio has been doing better than expected, it's easy to create a raise for yourself. If, on the other hand, we go through right as you begin retirement, have a year or two of poor returns, we may need to revisit the spending strategy, maybe reduce it a little bit in those early years so that you can catch up later. So this has to be dynamic. You need to be flexible, especially in that window of about five years on either side of retirement. So to wrap up the sequence of returns, risk is a real risk that you need to pay attention to as you come into retirement. And that first few years into retirement, you need to think about staying flexible with your retirement dates, with your spending amounts. Think like a pension plan. Be liability driven versus just driving your investment portfolio based on a risk tolerance score that you receive. Be active with your portfolio management. Attempt as much as possible to sell portions of your portfolio that are up to replace your spending bucket. Don't just blindly sell across the board. 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