Salvatore M. Capizzi, CEPA, is executive vice president of Dunham & Associates Investment Counsel, a wealth management and trust services firm. Dunham was established nearly 40 years ago.
Russ Alan Prince: What is sequence risk? Why should retirement savers be concerned about it?
Salvatore M. Capizzi: Sequence risk refers to the danger of running out of money due to the timing of market fluctuation during the withdrawal phase of your retirement investments. It revolves around the order in which investment returns occur and can significantly impact portfolio outcomes, especially for retirees. The concern is that experiencing poor market performance early in retirement makes it challenging even if the market recovers later and can deplete your portfolio faster.
Let’s assume, for example, you and I retire at age 65, and we both experience the same hypothetical return patterns: 10 years of a 6% return, 10 years of a 3% return, and 10 years of a flat 0% return. However, the difference is our sequence of these returns.
You started with 10 years of a 6% rate of return, followed by 10 years of a 3% return, and then 10 years of a flat 0% return. I, on the other hand, started with a flat return for 10 years, then 10 years of a 3% return, followed by 10 years of a 6% return. Same returns, just a different sequence of returns, even though we both averaged an identical, hypothetical 2.97% rate of return.
The devastation caused by sequence risk when taking retirement distributions can be considerable. Even though neither of us had a negative return in our retirement years in this scenario, I went broke 23 years later and ran out of money at age 88. You, on the other hand, with the same 2.97% average rate of return and the same 10-year returns but in a different sequence, would still have plenty of assets after 30 years. In fact, if we assume a 0% return from age 85 going forward, you will not run out of money until you are 105 years old!
Prince: How do you help retirees and financial advisors with HNW clients to mitigate sequence risk?
Capizzi: At Dunham, we have studied the concept of sequence risk because it directly affects the independent financial advisors and RIAs we work with, who mainly serve pre-retirees and retirees.
Through our Dunham Retirement Income Program, we offer a comprehensive retirement income planning tool at no annual fee for financial advisors. Once the planning is complete, we develop fully diversified and customizable investment programs that can contain equities from developed and emerging economies, U.S. bonds, international bonds, and alternative investments, including real estate, long/short strategies, and tactical managers.
But then comes the most important step in our battle to potentially take the edge off sequence risk, our OracleDC investment program. Warren Buffett inspired us to create this program by saying, “Be fearful when others are greedy and be greedy when others are fearful.”
When markets are in a down cycle, we increase our equity position. When markets are in their up-cycle, and equities may be selling at much higher prices due to what Alan Greenspan called “irrational exuberance,” we will systematically sell part of our equity position.
Here is the key for retirees to assist in mitigating sequence risk. The process, which is an unemotional algorithmic approach, means the retiree owns fewer equities when the market is hitting new highs in its up-cycle and owns more equities when the market cycles to the bottom. This should mean lower sequence risk and accelerated recovery time. And just like our planning program, we do not charge clients an additional fee for this program.
Prince: What wisdom from Warren Buffett drives your approach, and how is it relevant to retirees?
Capizzi: As I mentioned, OracleDC was inspired by the wisdom of Warren Buffett, who was influenced by Benjamin Graham, the “father of value investing.”
In his 1949 work The Intelligent Investor, Graham illustrated the emotional unpredictability of the stock market through the character of “Mr. Market.” Mr. Market exhibits fluctuating emotions, occasionally becoming overly optimistic and inflating stock values beyond their intrinsic worth. Conversely, he can also become gloomy and fearful, leading to the undervaluation of stocks below their fundamental value. OracleDC was conceived to leverage the swings in Mr. Market's sentiments on behalf of investors.
Therefore, OracleDC sells to Mr. Market when he is greedy and buys from him when he is fearful, and as I mentioned before, investors will own less equities at the top of a market cycle and own more at the bottom. This is a truly unique strategy that, in our view, takes the edge off sequence risk and potentially accelerates post-downturn recovery time for retirees.
Prince: What is the most important thing for retirees to keep in mind about market cycles over the long term?
Capizzi: In my view, markets have historically moved in cycles, in large chunks, and in short time periods. The most important consideration for retirees regarding market cycles over the long term is the potential impact of sequence risk on their portfolios. Given that retirees are drawing down their assets to cover living expenses, experiencing poor market performance early in retirement can significantly impact the sustainability of their retirement funds.
I firmly believe financial advisors can play an important role in guiding retirees through their retirement via income planning. Advisors should employ investment strategies that sculpt trends instead of chasing them.
Russ Alan Prince is a strategist for family offices and the ultra-wealthy. He has co-authored 70 books in the field, including Making Smart Decisions: How Ultra-Wealthy Families Get Superior Wealth Planning Results.