In our second Atheneum article for this quarter’s Retirement Income subject, we discuss the benefit of having multiple income streams during retirement. To understand the advantage of having multiple income streams, it is important to first understand one of the most important factors that affects portfolio longevity when taking income: sequence risk. According to Investopedia, sequence risk can be defined as “the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments.”¹ A poor market environment early in retirement has negative effects on a portfolio that may influence the overall ability to generate a reasonably expected income stream over time.
For example, suppose a retiree has $100,000 and requires $4,000/year in retirement (4% distribution) adjusted up by 3% per year for inflation. Also assume the retiree makes 5%/year. Holding everything constant, if the retiree experiences a -20% return in one single year, the results vary considerably based on when the -20% occurs. If the retiree experiences the negative return in year 1, the portfolio runs out of money in year 24. If the retiree experiences the negative return in year 5, the portfolio runs out of money in year 26. If the retiree experiences the negative return in year 10, the portfolio has $76,000+ left at year 30. The biggest challenge to retirement planning is that we do not know when these negative years will occur and for any one specific scenario, it may be at the worst possible time. Unfortunately, none of us own a crystal ball in our office.
We can combat sequence risk by owning multiple asset classes that provide different sources of income. This may include assets such as stocks, bonds, real estate, annuities, CDs, cash, etc. By owning diverse asset types, a retiree can rely upon one asset over another if a specific area is performing poorly. In the example above, if the retiree owned a real estate property, during the market selloff, the retiree could consider relying more heavily on the real estate income or even possibly consider liquidating the real estate and using that asset for income while the markets rebound.
Additionally, owning multiple assets that provide income streams traditionally will reduce sequence risk by reducing the overall income dependency on a certain asset. Consider a retiree whose income is comprised of 20% rental income, 10% annuity, 30% stock dividends, 15% bond dividends, and 25% Social Security. The risk of each associated asset (lack of renters, inflation, market correction, lowering bond yield, entitlement reform, etc.) is hedged by the other assets and somewhat contained to a smaller portion of the overall income need. This may not be a viable option for all retirees, but for those who have the ability to own more diversified income it may be an advantage in the long-term.
There is not a perfect way to generate retirement income and each person’s individual scenario will dictate what opportunities they are afforded. However, similar to investing in multiple asset classes for an investment portfolio, we believe that retirees who have multiple sources of retirement income generally have more protection against sequence of returns risk and single asset class risk.