Understanding Sequence of Returns Risk in Retirement
Stepping away from a career and the earned income associated with it marks a significant life transition for most. A transition where financial stability can appear to become more fragile. As a new retiree shifts from an earned income to relying on the cash flow produced by their investment portfolios, they’ll likely encounter a unique threat to their retirement cash flow known as "sequence of returns risk." As you’ll see, the sequence of returns one experiences in retirement has the potential to significantly impact one’s retirement cash flow, legacy objectives, and peace of mind. In this insight, we'll delve into what sequence of returns risk is, how it impacts someone living off cash flow produced by a portfolio, and strategies one can implement to mitigate the potential consequences. Lack of awareness could easily constrict one’s freedom, fun, and fulfillment throughout their retirement.
What is Sequence of Returns Risk?
Sequence of returns risk refers to the order in which investment returns occur over a period of time. When you're in the accumulation phase of your life (pre-retirement), the order of returns matters less because you're consistently contributing to your investments. However, during retirement, the timing of market ups and downs can have a profound effect on the longevity of your portfolio and subsequent peace of mind.
Imagine two retirees, Amy and Michael, who have the same average annual returns over their retirement period, but experience those returns in different orders. If Amy experiences poor market returns early in her retirement, she could be forced to withdraw a larger percentage of her portfolio to cover expenses, locking in market losses and leaving her with less capital to benefit from potential market recoveries. Michael, on the other hand, experiences strong returns initially, allowing his portfolio to grow while simultaneously taking withdrawals. This fundamental difference highlights the impact of sequence of returns risk.
The Domino Effect on Retirement Portfolios
When retirees experience poor returns early in their retirement, they are withdrawing funds from a shrinking portfolio. This can lead to a "domino effect" where the compounding of negative returns and ongoing withdrawals deplete the portfolio at a faster rate than if the poor returns occurred later. This scenario can be particularly problematic if the portfolio is not given sufficient time to recover before additional withdrawals are needed.
Let's focus on the first 10 years of a 30+ year retirement timeframe. Both hypothetical scenarios, over the first 10 years, achieve identical annual returns in different sequences to illustrate the impact of sequence of returns risk on retirement portfolios.
Scenario 1: Favorable Sequence of Returns (Michael)
• Year 1: +12%
• Year 2: +14%
• Year 3: +8%
• Year 4: +4%
• Year 5: +7%
• Year 6: -4%
• Year 7: +1%
• Year 8: -5%
• Year 9: +3%
• Year 10: +4%
Scenario 2: Unfavorable Sequence of Returns (Amy)
• Year 1: +4%
• Year 2: +3%
• Year 3: -5%
• Year 4: +1%
• Year 5: -4%
• Year 6: +7%
• Year 7: +4%
• Year 8: +8%
• Year 9: +14%
• Year 10: +12%
With these identical annual returns in different sequences, let's calculate the hypothetical portfolio values at the end of the 10-year period for both sequences, assuming an initial portfolio of $1 million and a fixed $50,000 annual withdrawal:
Scenario 1: Favorable Sequence of Returns (Michael)
• End of Year 10: Portfolio value = $946,639
Scenario 2: Unfavorable Sequence of Returns (Amy)
• End of Year 10: Portfolio value = $809,652
These 10-year scenarios further emphasize the importance of sequence of returns risk in retirement planning – two completely different trajectories for the remainder 20+ years of Michael and Amy’s retirement. Even with identical average returns over the period, the order in which those returns occur can lead to vastly different outcomes for retirees. If these returns were repeated again over the next 10 years, Amy would have a significantly greater risk of running out of money in her lifetime. This highlights the need for a well-developed framework of careful planning, strategic withdrawal strategies, and a well-diversified portfolio to mitigate the potential impact of unfavorable market returns at the onset of retirement.
Mitigating Sequence of Returns Risk
While sequence of returns risk cannot be eliminated entirely, there are strategies that retirees can employ to help minimize its impact:
Final Thoughts
Sequence of returns risk is an important consideration for anyone producing retirement cash flow from an investment portfolio. Coordinating and integrating multiple strategies to mitigate unforeseen risks can significantly impact the probability of success in retirement.
Remember, while you can't control market returns, you can control how you plan for and respond to them. Through collaboration and leveraging our experience, we can implement robust strategies to help mitigate these risks. Ultimately, creating greater clarity, confidence, and capability to continually expand your freedom.
*Guarantees are based on the claims paying ability of the issuing insurance company.