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Don't be scared by sequence-of-return risk

My husband was out walking a couple of evenings ago when he passed a cyclist on a tandem bike in our neighborhood. The cyclist, full of Halloween cheer, had positioned a glow-in-the dark plastic skeleton to occupy the tandem’s rear seat. The skeleton had articulated joints and its feet were fastened to the rear pedals so that it appeared as if the skeleton was actually sharing the work of riding the bike. Of course, even a real skeleton would hardly be useful to move a bicycle forward, particularly up a hill. Without muscles, it’s hard to make a contribution of physical energy. On the other hand, the skeleton’s glow-in-the-dark coloring may serve to protect the whole bicycle and the human rider if the heightened visibility prevents other cyclists or cars from crashing into them when it’s dark outside. Of course, if the bicycle does crash, the plastic skeleton is going to survive virtually unscathed, while the rider may be hurt.

Last week, we talked about sequence-of-return risk. That’s the risk that the market is going to tank just at the start of an extended financial commitment, such as retirement; and as a result, the funds you have saved to cover that commitment drop precipitously, making it difficult for them to recover and provide enough money to fully complete the goal. Here’s the most basic way to protect yourself from sequence-of-return risk. As you near and enter the period, during which you need to rely on savings, you move a portion of your assets in a very low risk investment. The portion should be sufficient to “ride out” a typical market downcycle of around five years. For example, if you calculate that, in addition to your Social Security, you will need $45,000 a year of pre-tax income to maintain your desired retirement lifestyle, then as you approach your retirement date, you take a minimum of $45,000 x 5 or $225,000 and put it into bonds or bond funds. Bonds are a lot like that skeleton on the tandem bike. They hardly contribute to the forward and upward motion of your portfolio, but also, they are hardly damaged if the market crashes.

Having a sufficient supply of fixed-income securities will not prevent the equity market from dropping, but it will mean that you don’t have to sell equity securities when they are down and thereby lock in your losses. Instead, the equity securities—stock--will have time to recover. Most of the time, and certainly when the market is down, you sell the bonds to fund your retirement living expenses. As you “use up” one year’s worth, you move another year’s worth from stock to bonds. In our example from last week, if you retired at the end of 2007 and had 5 years’ worth of your retirement assets in bonds, you could have lived off those as the marked dropped throughout 2008 to its low in April of 2009, and you could have continued using them for five years until the fall of 2013, when the market would have largely recovered. Of course, at that point, you would want to shift another several years’ worth from stocks to bonds to build up your cushion for the next use.

Seeing yourself through an extended period of disability requires a two-pronged strategy. The first starts when you take a job. Take a close look at the long-term disability benefits offered by your employer. Typically, these will only replace a portion of your pre-disability income, say 60%. Moreover, the salary to which the percentage can be applied may be capped. This means that high-paid employees may get a lower percentage of their pre-disability income. And the formula may not take bonuses into account. Figure out the maximum disability benefit your employer-sponsored insurance will pay and compare it to a realistic estimate of your monthly household expenses. If you wouldn’t be able to cover your current bills, then you probably need additional private disability insurance, and you should talk to a reputable disability-insurance broker, ideally one who has experience with professionals in your industry. Having sufficient regular cash inflow from disability insurance means you don’t have to rely on selling portfolio assets to make ends meet, and you don’t have to worry about market downturns during your time off work. Of course, with the best disability insurance, you may find that the disability itself generates extra costs that are not fully covered by medical insurance. Or another family member may have to reduce her/his working hours to act as a caregiver, so the overall family income drops. In the event that you will have to rely somewhat on selling down portfolio assets while on disability, you should take the same steps as a retiring person and move a buffer portion of invested assets into fixed-income securities.

The buffering strategy works well to reduce sequence-of-return risk in retirement and even, in combination with a good disability insurance, for periods of long-term disability from which recovery and return to work are expected. Having a fixed income buffer is also necessary to offset the impact of sequence-or-return risk that hits one’s portfolio at the start of a long-term care event. Necessary, but not sufficient, because this kind of care can be very expensive. Although treatments that can heal, cure or improve illness or disabling conditions are covered by health insurance, including Medicare, custodial care is not. Custodial care such as assisting with bathing, dressing and other activities of daily living, or monitoring a person with dementia to prevent wandering or self-harm often comprises the majority of long-term care needs. While Medicaid can cover custodial care, it can only do so for people of extreme poverty, and it may not pay for the quality of care that the patient of her/his family desires.

Long-term care can vastly increase monthly expenses in retirement. In the event that a market downturn coincides with the early days of a long-term care event, any fixed income buffer may be exhausted long before the market has a chance to recover, and the care recipient might end up selling a significant amount of assets at a loss. Particularly if you come from a family with average or above-average longevity and/or if your family has a history of the kind of physical or mental conditions that require long-term care, you may want to consider insuring at least some of this risk which, in combination with sequence-of-return risk, could entirely gut your financial plan. This is even more important for parents of children or adults with special needs because if the parents exhaust all their assets on long-term care, there will be nothing left to fund the adult child’s supplemental needs. There are a variety of standalone and hybrid insurance products that can help you manage long-term care. Talk to a trusted broker with long-term care expertise.

It probably takes our neighbor longer to get where he’s going, lugging both his tandem bike and its non-contributing second rider around, than if he would ride singly. On the other hand, the skeleton’s neon coloring and higher visibility after dark may prevent the whole bike and its human rider from getting hurt in a serious crash. Managing your investment portfolio to include a sufficient amount of fixed-income securities and making strategic purchases of disability and long-term care insurance will preserve you from the scariest impacts of a market crash that could otherwise undermine your most important financial goals.

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