New Retirees Face Unique Risks from Unsteady Markets. Plan to Protect Them.
The last 12 months have delivered an atypical double whammy of equity and bond declines. History shows strong rebounds should follow, but not necessarily before additional volatility. Though rare, back-to-back years of challenged stock prices can occur—and need to be carefully managed around, especially for retiring clients.
Diversification is the golden rule when it comes to navigating short-term market challenges and smoothing out returns. Certainly, 2022 was a prime example. Yet looking toward this year, investors’ prospects are similarly uncertain—especially for clients at or nearing retirement.
The fact is a negative year for both bonds and equities is rare. Yet rarer still is a second consecutive year of equity declines. Last year delivered the former, while 2023 represents the first time that investors could see such a development in over two decades. Not since 2001-02, or for those with longer memories, 1973-74, have clients been exposed to such a prolonged stretch of market volatility.
No Advisor wants to see a client experience negative returns, but for ones nearing retirement, a prolonged slump is a particular worry. That’s because portfolios hit by sustained market declines at the time of retirement can suffer long-term structural impairments compared to clients who retire during more stable conditions (see Figure 1).
In order to build in a buffer against such a possibility In, Advisors can draw on a toolbox of tactics to shield retiring clients from what is sometimes called “sequence of return risk.”
This is a real risk to portfolios that shouldn’t be sugar-coated to clients who’ve done everything right and are ready to retire from a rewarding career.
Sequence of returns risk, explained
First, let’s address what sequencing risk means. As clients accumulate assets and grow their money for retirement—or the “accumulation phase of investing”—stock market gyrations are generally more tolerable. The longer time horizon allows their investments sufficient room to recover losses in the portfolio.
But as the client begins accessing retirement funds and creating an income stream, known as the ”de-accumulation phase,” the risks take on greater importance. This is especially so if a portfolio is subject to volatility at the beginning of retirement. Market fluctuations and the order in which positive and negative returns occur, or “the sequence of returns,” can have a material detrimental effect on retirement savings.
Make no mistake, this is a real risk to portfolios that shouldn’t be sugar-coated to clients who’ve done everything right and are ready to retire from a rewarding career, only to face a challenging two-year period that could have lasting consequences.
As Figure 1 illustrates, three similar retirement portfolios can end up having vastly differing outcomes depending on the progression of market conditions. In each scenario, the portfolio earns an annual average 5% over seven years and assumes a $60,000 withdrawal per year from an initial capital investment of $1 million. We can see that Portfolio 3, with a negative variable rate of return at the beginning, faces a greater depletion of capital and is left with a considerably lower balance compared to Portfolio 1 and Portfolio 2, at the end of year seven.
Figure 1 : Capital accumulation and depletion over a 7-year period
Each scenario has an average annual 5% per year return and assumes a $60,000 withdrawal at the end of every year. Initial capital investment is $1,000,000.
|Year||Retirement Capital Constant Return||Constant Return Rate||Retirement Capital Variable High Start||Variable Return Rate (High Start)||Retirement Capital Variable Return Low Start||Variable Return (Low Start)|
Source: BMO Financial Group. For illustration purposes only.
Build a cash wedge
For clients who hit back-to-back years of negative returns, the outcomes are no doubt challenging – and, more often than not, many of them end up working longer than planned. That less-than-desirable reality underscores why many Advisors want to take steps to buffer clients from such turbulence well in advance of their target retirement date. One potential strategy is a “cash wedge.”
The idea is to create a wedge, or buffer, of cash that a client will live on in the first two to three years of retirement. The money is set aside in the years preceding retirement, and would allow their remaining portfolio to ride out the volatility untouched.
A typical example would be targeting $60,000 in annual spending for a new retiree with a $1 million portfolio. To construct a cash buffer, an Advisor would set aside that annual amount each year in the three years leading up to the client’s targeted retirement date, locking in income needs for the first few years rather than the client immediately begin drawing down on their portfolio during a hypothetical downturn.
Advisors need to help make that decision—to say to a client it would be wise to start locking in cash flow ahead of retirement, and that cash should be parked in short-term instruments such as a money-market or short-term bond fund to see them through the rough patch and allow their savings to benefit from the market recovery.
Plan ahead with a 100/100 segregated fund
Another way to manage sequence-of-returns risk and ride out adverse market conditions is with a segregated fund such as BMO Guaranteed Investment Fund (GIF) 100/100. Aside from the estate and death benefit guarantees a segregated fund provides, newly retired clients will have locked in 100% of their principal amount at maturity* regardless of what’s happening in markets.
Moreover, the market gains are reset monthly up until 10 years before maturityϮ, meaning the client or beneficiary will receive the full principal upon a maturity date that aligns with their retirement timeline, or the market value of the GIF upon maturity, whichever is higher. With maturity dates that span 15 to 25 years, these funds can lock in the upside and keep clients protected during a downturn.
While inflation worries, recession anxieties and negative investor sentiment are pressing concerns right now, it’s reasonable to expect stronger growth and meaningful market gains at some point in the not-so-distant future. Times like these serve as a healthy reminder of why it’s vital to orchestrate a cash wedge strategy, which will not only safeguard clients’ retirement funding in the near-term, but also lock-in capital gains when markets eventually turn up again.
Pro tip for GIF 100/100
- Highest level of capital guarantees:
- Capital protection: Up to 100% of investment returned in as few as 15 years*
- Estate protection: Up to 100% of investment paid to beneficiary on death**
- Automatic monthly maturity guaranteeϮ
- Option for triennial death guarantee resetsϮϮ
- Prestige Class pricing for high-net-worth clients
Please contact your BMO Global Asset Management wholesaler for any additional support and guidance.
* At Maturity: 100% on deposits made at least 15 years and 75% on deposits made less than 15 years from the Maturity Date, less a proportionate amount for withdrawals.
** At Death: 100% on deposits made before the Annuitant’s age is 80 and 75% on deposits made on or after age 80.
Ϯ Automatic monthly resets of the Maturity Guarantee Amount occur up to and including 10 years from the Maturity Date.
ϮϮ Automatic resets of the Death Guarantee Amount occur every 3rd policy anniversary up to and including the last policy anniversary before the Annuitant’s 80th birthday. Must be selected at time of application. Additional fee applies.
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