Understanding Sequence of Returns Risk with Bud Kasper

[00:05:07] Dean Barber: Yes.

[00:05:08] Bud Kasper: And the biggest worry that you have is what if a bear market starts at the time that I’m starting to take distributions? Well, that’s when you have to have a comprehensive financial plan that actually takes you through the process of taking distributions out of the account, and historically, looking back to see what the results would be.

[00:05:25] Dean Barber: Well and, of course, Bud, through the guided retirement system that we use, we can actually stress test a plan that says, what if you have a bear market at the beginning of retirement? How does that impact your ability to do what you want to do? You can clearly see that, and how that bear market at the beginning of retirement is going to impact you is going to be based on your asset allocation.

It’s not as simple as just saying, “Hey, you head into retirement, go 60/40 in your portfolio.” It’s just not that simple. The thing that I think a lot of people don’t really understand, Bud, is that when you think about the sequence of return during your accumulation years when you’re saving, it doesn’t matter.

[00:06:12] Bud Kasper: No.

[00:06:13] Dean Barber: That sequence of return is irrelevant. In the article that you wrote, which people can get through a link in the show notes, they’ll see two charts. The first chart that I want to go through is the sequence of returns in a person who’s accumulating. And so, we’re referencing a 25-year period here, and we’re just looking at an average rate of return of 6%. Over that 25-year period, it didn’t matter the order in which the returns were achieved. You still wound up with the same $4.2 million on a million-dollar initial investment.

[00:06:50] Bud Kasper: Right.

[00:06:51] Dean Barber: And we could do one where your dollar cost averaging and you’re going to see a little bit of a difference. But when you get into retirement, one of the things I like to say is that you can’t spend an average annual return. You can only spend what the portfolio actually makes in that year. And if you’re not spending what the portfolio makes in that year, you’re actually spending principal.

So, if you have a negative return, all of a sudden in those early years of retirement, now you’re spending principal as opposed to earnings, and it can turn into a snowball effect where if we use the same exact example, only you start with the million dollars and you’re taking $50,000 a year out, so you’re taking a 5% withdrawal. The one where you had negative returns up front ran out of money, if you’d retired at 65, you ran out of money by age 83.

[00:07:43] Bud Kasper: Yes.

[00:07:44] Dean Barber: And in the one where you had the sequence of returns flipped, you had $3.8 million at age 83.

[00:07:50] Bud Kasper: Isn’t it amazing?

[00:07:51] Dean Barber: Your average annual return was exactly the same, it was just the order in which those returns were received.

[00:07:55] Bud Kasper: Yeah, I created a term a few years ago applying to what you just talked about, and that is where you’re taking money out of the account at the same time, you’re losing money in your portfolio, and that is double negative compounding.

[00:08:07] Dean Barber: Right.

[00:08:08] Bud Kasper: So, how in the world do you take a million dollars? And by the time you’re 83, be out of money, taking $50,000 out a year, will you have to look at the sequence of returns risk? So, quite simply stated, if you have losses at the beginning of the period, you’re more than likely to fall victim to the sequence of returns that I’m talking about here.

So, how does a retiree avoid that since you can’t predict necessarily what’s going to be happening in the marketplace? The answer is you plan around that by having an excess amount of money that you will have reserved for yourself. Yes, maybe you do curtail a little bit of your spending in those years if we’re in a difficult patch, but at least you have an income stream that is calculated into the plan to be able to support you.

If you take the average bear market, which is somewhere around 9 to 18 months in duration, you should be able to come back out of that and then redeploy money at specific periods of time to be able to get what you want. And that is to protect your principal value, hopefully, make it grow and get your distribution simultaneously.

[00:09:17] Dean Barber: Yeah, that’s a great point, but I think there’s more to it than just setting aside a little bit of money that you can spend for a few years, kind of the bucket strategy, that is an approach, right? But I think you can use some more common sense. And to use common sense, you have to remove emotion from your decision-making process in retirement. So, let’s back up in time to a time where you and I both saw a lot of warning flags, warning flashing red lights and saying, “Hey, something is wrong here.”

And that was just prior to the Great Recession, when the subprime mortgage crisis was really starting to rear its ugly head. And of course, you and I know how that whole thing turned out, and the stock market wound up falling by over 50%, and most of that 50% loss came during the last half of 2008 and the first quarter of 2009. So, the majority of that loss came in a nine-month period.

Now, if people didn’t heed those warning sides and they just simply said I’ve got a 60/40 portfolio, so I’m safe, those people got smashed, right? They absolutely got killed. But in particular, you said, “Look, this is time to take some money off the table. Let’s reduce the amount of money that we have in equities. Let’s put potentially some inverse strategies as a hedge in that portfolio.

And if we don’t get the downturn in the market, it might be a little bit of a drag on the overall return. But if we do get the downturn in the market, it can help buoy up the value of that. And so, there is a tactical component.

[00:11:11] Bud Kasper: There is.

[00:11:12] Dean Barber: So, I want you to talk about how you think about that.

[00:11:13] Bud Kasper: Well, first off, I always tell clients the preservation of your money is just as important as the return on your money. And so, if we take it from that approach and we’re eyes wide open in terms of what the conditions are that we’re investing in at any particular period of time, it is necessary for us to be able to find alternatives that might be able to provide a counter to what a falling market might represent.

And it could be as simple as having a higher emphasis in bonds in your portfolio. If we take that thought that I just shared with you, Dean, and we look at what’s happening today in our current year, that wouldn’t be necessarily the solution that you’re looking for. So, what do we do? Give up? No, we have to still seek out other alternatives than the traditional ones and staying overexposed because so many people said, “Don’t ever touch it, let the money roll, you’ll come out of it.” Not a true statement when you’re taking distributions.

[00:12:11] Dean Barber: That’s right. That’s why I said the rules change when you get into retirement. When you’re in your accumulation phase, that sequence of return isn’t nearly as critical. Now, it can be critical in that last four or five years of your retirement. I’ll give you an example. We met with a person in late 2021. One of our CERTIFIED FINANCIAL PLANNER™ professionals did, and I got an opportunity to sit down and review the financial plan.

And what we noticed was this couple was planning on retiring mid-2022, and within their 401(k) plan, which was the majority of the assets that they had, they were 100% in the S&P 500 index fund. And so, we got a list of all of the different options that they have with inside their portfolio, and they had about 10 of those different lifestyle funds or life cycle funds, age-based type funds, retirement date, target-date funds, whatever you want to call, they go by a lot of different names.

[00:13:09] Bud Kasper: Yeah, which, by the way, is a default mechanism in most 401(k) plans.

[00:13:14] Dean Barber: Well, so here’s the deal. I had a bunch of those, and then they had the S&P 500 index, they had a mid-cap index, they had a technology index and a couple of other index funds. And then they had the Barclays Bond Agg as the fixed income, and then they had a short-term treasury.

And so, we’re looking at all of the different options, and I’m saying, “Okay, we can’t afford to have 100% of your money exposed to the stock market at a time when asset valuations are out of control, we need to cut back.” Well, of course, we look at the year-to-date returns as of the date that we looked at this, and the Bond Agg was a negative 1.63 year to date, and the S&P 500, of course, was positive, about 25% year to date.

The comment, of course, and understandably so, was why would I take money out of something that’s earning 25% and put money into something that’s losing 1.63%?

Of course, when you think about that from a logical standpoint, it doesn’t make any sense, especially if there’s emotion involved. But what I said was, “Look,” I said, “I wouldn’t go to the Bond Agg right now because of where we are with interest rates and because where we are with inflation, etc., but you have a stable value fund in here as well. And what we should do is we should set aside at least three years’ worth of your first three years of retirement spending that you’re going to need into that.

And then, with the rest of it, we’ll build a more balanced portfolio, but we need to think about that really in two different components because if the sequence of returns hit that couple wrong, and we wound up with a severe bear market over a 9 or an 18-month period, it could drastically change the outcome of their ability. But if we have at least three years’ worth of spending, now, all of a sudden, you’re 9 to 18-month average bear market, we can go through that. We can come back out the other side. And then when you come out the other side of a bear market, you typically have some pretty good results.

[00:15:20] Bud Kasper: Sure. And once again, what you’re stating is rebalancing the portfolio for the situation that we’re in, and that does work. Sometimes being more defensive is the most prudent approach to what you’re trying to do, which is what, as I said before, we’re trying to preserve and grow. And in the process of that, there are techniques that are utilized at different times and market cycles that allow us to be able to maneuver through those difficult times and still come out a winner in the end.

[00:15:48] Dean Barber: Yeah, that’s exactly right. And the thing is that you have to be attuned to what’s happening in the economy and in the markets as a CERTIFIED FINANCIAL PLANNER™ professional if you’re going to be advising an individual on what they should do. And I think that we’ve talked about sequence of returns a lot. Sequence of returns risk was a critical thing back in the Dot-Com Bubble.

Sequence of returns risk was another critical thing during the financial crisis. On the other side of the financial crisis, there’s been nothing, right? We’ve had a couple of years that we’re maybe minus 5%, 6%, 7%, but it’s been basically a bull market since, what was it? April of 2009 with the exception of what we had happen for a one-month period with COVID.

[00:16:35] Bud Kasper: You and I have referenced many times an article from Morningstar called the Alpha, Beta, and Now… Gamma. And what that was, it’s very appropriate for the subject that we’re talking about today because the gamma part of it– by the way, alpha means a growth factor, beta means risk factor, and now, the gamma factor was dynamic withdrawal strategies.

[00:16:57] Dean Barber: That was one of the five different financial planning techniques mentioned in that article.

[00:16:59] Bud Kasper: Right. With Paul Kaplan and David Blanchett, I believe, authored that. You can see it on the internet if you want to look it up. But it illustrates perfectly that there are times when we make more, whenever I say it, adroit adjustments in the withdrawal strategy to what? Maximize the results and still find ourselves in a position where we will have the opportunity to continue to have the money grow.

[00:17:24] Dean Barber: Right. Well, let’s explain that dynamic withdrawal strategy. But because I think it’s something that it’s very appropriate, and this is really specifically for people who are in retirement that are relying on their portfolio to deliver income. This wouldn’t necessarily apply to anybody that’s not retired or anybody, even within five years of retirement.

This particular strategy does, this is after you retired and asking your money to produce income. So, we’ll use that same example, Bud, the 60/40 portfolio, and if you begin 2021 with a 60/40 portfolio, by the time you get into late December, you’re sitting at about a 75/25 portfolio. So, 75% equities, 25% fixed income, and you likely have a return somewhere in the mid-teens. And so, if your distribution strategy asks for a 5% withdrawal, let’s just assume that’s the number, you made three years’ worth of income in a single year. Okay.

So, you already took the one year, the 2021, now what we’re going to do is we’re going to go ahead and harvest the next two years’ worth of income, we keep it in the same account. We just harvest that and put it into a stable value type of investment so that we know that our next two years of income are already covered.

[00:18:47] Bud Kasper: Right. Exactly right, Dean. And it sounds simple, and it is. It’s just a matter of execution and understanding what the objective is and more importantly, understanding what the downside risk is if you don’t.

[00:19:00] Dean Barber: And I think that’s the key because from an emotional level, it’s very difficult to do that because the two strongest emotions that we all have are fear and greed. And in a scenario like what I just talked about, greed is going to be an overriding emotion that’s going to cause a person to say, but that’s doing so well. Why should I do that? Well, because we don’t know what’s next. And with inflation really rearing its ugly head with the possibility of higher interest rates, the possibility of higher taxes, more corporate regulations, the list goes on and on with everything that’s happening, it’s time.

Do it. And guess what? If the market continues up, you’re still going to have a significant amount of money in the market and you’ll likely have as much dollars in the market as you would have had at the beginning of the year or more. You just harvested the gains that you made and set that aside for a couple of years of income.

[00:19:51] Bud Kasper: The sad part of this story is in terms of who you’re working with, because too many people came up with basically saying, whatever you do, don’t get out of the market because if you get out of the market and it changes direction, you’re not going to be in at the beginning. Well, that’s all fine when you’re younger and you’re putting money in and you got a lot of years to contribute and that kind of stuff.

But in reality, in retirement, this is the most serious time of your investing life. And that’s why you cannot just go in and do the same things that you did in the growth phase. Now, you’ve got the seriousness of making this money last your lifetime for yourself and your wife or your husband.

[00:20:29] Dean Barber: Right. Now, the only exception to that, Bud, would be if through the financial planning process, let’s say that somebody goes into retirement, and they’ve got their Social Security, maybe they’re lucky enough to have a pension and let’s just say, they’ve got $3 million accumulated to distribute income. And through the financial planning process, you can see that there is, if they had $500,000 less, they could still achieve everything they wanted to achieve in retirement.

[00:21:00] Bud Kasper: Right.

[00:21:01] Dean Barber: So, now, you can all of a sudden take that $500,000 that they don’t need. It’s not going to be a critical part of their ability to achieve their retirement goals. Now, you can set that aside, invest that like you’re 25 years old, and look at that as a legacy piece, an inheritance piece, right?

[00:21:20] Bud Kasper: You use the right word there and that particular, and by the way, there’s not a better investment to have for that legacy piece than a Roth IRA. And so, these are all planning concepts that from time to time change because of conditions in the economy and in the market themselves. But with the proper approach and understanding what risk versus reward is, you should be able to manage through it with the right advisor.

[00:21:46] Dean Barber: Bud, let’s go back to the dot com bubble because I mean, we’re now going back almost 22 years. And back then, they were saying a safe withdrawal rate was 6%. Some people said a safe withdrawal rate was 7%. You’d experienced multiple years in a row of double-digit returns in the market, five years in a row.

And people thought that it was different, right? The brick and mortar’s was dead. It’s all tech, it’s all dot coms. And the dynamics they thought had changed. My question to you is, have you met anyone or did you meet anyone in that period of time that had retired either in the late 90s or right at the beginning of 2000 that didn’t have a plan, that didn’t have a good withdrawal strategy, that got greedy and wound up having to go back to work because their plan failed?

[00:22:44] Bud Kasper: Yes, I’ve had that experience, sadly.

[00:22:47] Dean Barber: I know, and I have too.

[00:22:48] Bud Kasper: Yeah.

[00:22:49] Dean Barber: And I met far more than one and more than a handful over that period of 2003, 2004, 2005, where people did what you said and that is just wait, it’ll come back. Well, again, like you’re 25 years old, it doesn’t matter.

[00:23:06] Bud Kasper: With that dot com bubble, and it’s indelibly set in my mind, if you will, 1995 through the end of 1999, an incredible period of time of growth. And you’re absolutely right. The S&P 500 did well, but the Nasdaq 100 was out of sight.

[00:23:20] Dean Barber: Oh my gosh, yeah.

[00:23:21] Bud Kasper: And that’s why they called it, when we went over in the 2000 and we start the beginning of the new century, new decade, new year, Y2K, all that stuff. And now we see an implosion. So, now we see the market going down, and in a period of time of three years, the market lost 46.5% of its value.

[00:23:39] Dean Barber: And it was a slow bleed.

[00:23:40] Bud Kasper: Yeah.

[00:23:41] Dean Barber: It wasn’t a quick drop that we saw in…

[00:23:44] Bud Kasper: Yeah, it was 10%, 13%, 23%, and some change.

[00:23:48] Dean Barber: Yeah. And so, it was a really slow bleed. And that’s the S&P. The Nasdaq over that same period of time lost 70%.

[00:23:56] Bud Kasper: Yeah.

[00:23:57] Dean Barber: Right? So, there were a lot of people that either had to postpone their desired retirement date because they didn’t pay attention, they did the buy and hold strategy, or they retired and didn’t understand that things were different in retirement and they wound up having to go back to work, or they wound up having a far smaller income stream in retirement than what they had desired, drastically then affecting.

Bud, we saw the same thing occur in 2008, and a lot of that was not only in the stock market but was also in the real estate market as well. Of course, those aren’t people that our clients. Those were people that didn’t have an advisor, or if they did have an advisor, that advisor subscribed to the idea that it’s just buy and hold while I call that buy, hold, and hope.

[00:24:52] Bud Kasper: Yeah, right.

[00:24:53] Dean Barber: Let’s just hope it works.

[00:24:54] Bud Kasper: That’s a good phrase. Yeah, look, going back to the dot com bubble with the 46.5% drop that I’m referencing with the S&P 500 returns, and then you look at what happened in the next years, it was positive, okay, but what I want you to know is it took at that time almost three years to get back the losses that they experienced. Now, even though the market’s starting to come back, if you’re still taking distributions, yes, you’re getting some improvement, but the distribution is still draining the account, and it’s such a critical factor.

If you go back to the Great Recession, which everybody remembers because the phrase was coined, my 401 turned into a 201, and you look at what happened with that, it took another series of years to get back. In fact, it was almost three and a half years for it to get back to, even after the losses that people experience at that time. That is a risk.

[00:25:47] Dean Barber: Well, and if somebody had retired in 2000, and they had a 60/40 portfolio, and all they did was take 5% per year and they tried to keep up with inflation, by the time they ran to about 2010, 2011, they’re within a couple of years of running out of money.

There’s also a video that we did on that that you can check out, and we’ll have that in the link in the show notes as well, and it’s called Retiring at Market Highs. And so, it’s critical, really, that people understand, those people that are five years out from retirement right now, those people that are already retired right now, you need to be really paying attention to the statistical data that we’re seeing today and how it could impact your ability to get to retirement and then have the lifestyle that you want through retirement. That’s really what it’s all about.

[00:26:43] Bud Kasper: That is an outstanding program, and I hope people take advantage and take a look at it because what you uncovered for everybody to understand is what I’m talking about here, and that is the serious consequences of sequence of returns risk, but there’s two factors that are left out of that as well.

[00:26:59] Dean Barber: Right. Inflation is a big factor, and we actually dive in deep on inflation on that program as well.

[00:27:05] Bud Kasper: Yeah, and again, that’s another thing we have to contend with. And again, if you’re not doing a comprehensive financial plan, Dean, where you’re taking all these variables into consideration, you are flying blind. You’re just hoping, as you stated earlier, that the results will turn around, and I’ll get another 10 years of the bull market and I’ll be happy again and I’ll recover the losses that I might have already experienced.

[00:27:29] Dean Barber: Yeah, no. There’s a time to be safe and there’s a time to be more aggressive. Nobody, I don’t care who it is, is going to be able to say, this is the time that you need to be safe, and they’re going to be exactly right. Then the next day, the market starts to fall apart. Nobody’s going to be able to say this is the time that it’s time to be aggressive.

And you’re right at the bottom of the market. But if you can cut off the middle parts of that, Bud, and you control the drawdown, and then you have a strategy and a scenario that can tell you this is when it’s time to deploy more back into the markets and take off some of the hedging strategies and that you can smooth those returns out, and then following the other piece of that as well, you can also really get that dynamic approach and keep enough money safe that what’s fluctuating isn’t changing your life.

[00:28:30] Bud Kasper: Yeah, harvest the gains when they’re there, be conservative when we go through the rough patches, understand that there’s alternatives for us to be able to consider and stay with the plan.

[00:28:42] Dean Barber: Yeah. And so, I want to bring up a little bit on psychologically, what happens in these types of scenarios, Bud.

[00:28:53] Bud Kasper: Fear and greed.

[00:28:54] Dean Barber: Well, it’s fear and greed, but it can leak into marital conflict.

[00:28:59] Bud Kasper: It sure can.

[00:29:00] Dean Barber: Okay. If we’ve got a tough market, if you’ve done the planning, you’re going to be okay. Alright. And even though there’s been a tough market, and we might see a decline in what we still have in the equity position of it, the person that is a part of that couple that’s the more conservative person, they look at the decline in value on that piece that you’ve got out for a longer period of time, and their natural inclination is to cut back or canceling the vacation. We’re not buying gifts for the kids, we’re not giving money to the 529 plan for the grandkids.

And the other person is saying, “No, look, we’ve got this plan set up and we can still do these things.” But without clear visibility of how those market fluctuations have affected you, which is what our guided retirement system is designed to do, without that clear visibility, you’ll have that marital conflict and you’ll do one of two things, you’ll either wind up spending more than what you should or you’ll wind up not spending as much as what you could. And unfortunately, not spending as much as what you could is what we see happen the most.

[00:30:09] Bud Kasper: But if you’re spending time watching programs like these, I think you’ll end up understanding that it is in your control, and therefore, having a plan that is working specifically to your needs and making adjustments at specific times of duress, you can still have a very successful retirement.

[00:30:28] Dean Barber: Totally agree with you, Bud. Thanks for joining me here on The Guided Retirement Show.

[00:30:31] Bud Kasper: It’s my pleasure.

[00:30:32] Dean Barber: We’ll get you back on here sometime soon.

[00:30:39] Bud Kasper: Well, they can also listen to us on the radio show.

[00:30:41] Dean Barber: That’s right. Good point, Bud. Find America’s Wealth Management Show as well on your favorite podcast app. Bud and I are out there every single week talking about what’s hot and what’s going on, current status. There’s tax changes or whatever’s going on, we’re talking about it all the time.

[00:30:57] Bud Kasper: That’s right.

[00:30:58] Dean Barber: Thanks for being here.

[00:30:59] Bud Kasper: You bet.

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