Helping Advisors Mitigate Sequence-of-Returns Risk in Client Portfolios

In order to create income and liquidity, clients naturally begin selling off assets during retirement, which puts pressure on advisors to satisfy adequate return requirements with a dwindling asset base.

But during a market downturn, selling off assets and making withdrawals when overall returns are down, especially early on in the investment time horizon, is the single most detrimental course of action one can take in the context of managing sequence risk. In other words, when clients retire during a period of economic prosperity, their asset base may grow large enough to withstand an economic downturn. Conversely, if clients retire during a period of poor economic conditions, their asset base may never fully recover, or at least not enough to satisfy their goals.

Don’t Fall Into the Trap

So how can advisors avoid falling into this trap? Once a client’s specific needs and return requirements are understood, there are a few ways that advisors can help meet these objectives while mitigating sequence-of-returns risk (aka, sequence risk), which we will explore below:

Maintain a Cash Reserve

In order to avoid selling off assets during down periods, it is important to maintain a sufficient cash reserve to draw from. At the same time, advisors are faced with the challenge of balancing a sufficient level of returns while keeping a large enough reserve to sustain the client’s desired lifestyle given the reduction in returns you receive from holding cash investments.

Create a Bond Ladder

To potentially reduce the size of a reserve fund, one can create a bond ladder for clients. As an example, a client might have $200k invested in bonds but in a ladder structure where $20k is invested in 10 bonds that each mature one-year apart over 10 years: as each bond pays interest or matures, clients will receive cash flows at different points in time which can be used to purchase a new 10-year bond (to extend the ladder) or use some of the income to cover any reserve fund shortfall. Besides being a good way to invest in fixed income securities, bond ladders have natural, built-in liquidity that Advisors can take advantage of if necessary.

Reduce Portfolio Volatility

Once an adequate cash reserve has been established, advisors can turn their attention toward reducing portfolio volatility. The lower the volatility, the lower the impact of sequence risk. Reducing volatility can be achieved in a number of ways. One way is to increase exposure toward fixed-income assets, which by nature are less volatile than equities. Of course, this may not be appropriate for everyone’s risk/return appetites, so client circumstances & goals must be considered. Remember, volatility can be desirable early on in the investment life cycle as the client is in the asset accumulation phase, but as time winds down, clients will typically prefer to reduce volatility in order to protect their assets and focus on income rather than growth.

Adjust Spending Habits

Lastly, a simpler method of navigating sequence risk during adverse economic conditions is simply having the flexibility to adjust spending habits. If a client has other sources of income or perhaps is well-diversified enough to withstand a downturn without having to sell off assets at the worst possible time, then they will be better insulated against costly sell-offs.

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