What is sequence of returns risk and why does it matter?

Understanding Sequence of Returns Risk: A Critical Factor in Retirement Planning

As you approach retirement, one of the most critical risks you’ll need to manage is something called sequence of returns risk (SORR). This risk can significantly impact how long your retirement savings will last, even if your average investment returns look good on paper. In this article, we'll explore what sequence of returns risk is, why it matters, and how you can mitigate its effects to ensure a more secure financial future.

What is Sequence of Returns Risk?

Sequence of returns risk refers to the danger that the order in which you experience investment returns, particularly early in your retirement, can dramatically affect the longevity of your retirement portfolio. Imagine two retirees with identical portfolios and average returns over their retirement years. If one experiences a market downturn early in retirement and the other experiences the same downturn later, their financial outcomes can be vastly different.

Why Does It Matter?

The primary reason sequence of returns risk is so crucial is because it interacts unfavorably with withdrawals. If you start drawing from your retirement savings during a period of poor investment returns, you may lock in losses and significantly reduce your portfolio's ability to recover. This can lead to an accelerated depletion of your savings, potentially years before you anticipated.

Here’s a simplified example: Consider two retirees, both starting with $1 million and withdrawing $60,000 annually. If one suffers a market downturn early on, they might end up with significantly less money after a few years compared to another retiree who faces the downturn later, despite both having the same average return over time.

Real-World Examples and Scenarios

To illustrate, let’s look at two hypothetical scenarios:

• Investor A begins retirement just before a major market downturn. Despite an average annual return of 6% over five years, the early losses mean they end up with $83,288 less than anticipated after five years.

• Investor B retires after the market recovers. Even with the same average return and withdrawal strategy, they end up with significantly more in their account after five years due to favorable early returns.

This shows that it’s not just the average return that matters, but when those returns occur relative to when you start making withdrawals.

Strategies to Mitigate Sequence of Returns Risk

Managing SORR involves a combination of strategic planning and flexible financial management:

• Diversification and Asset Allocation: Ensure your portfolio is well-diversified to balance growth with stability. Consider reducing stock exposure as you near retirement to minimize potential early losses.

• Dynamic Withdrawal Strategies: Instead of withdrawing a fixed amount, adjust withdrawals based on portfolio performance. During market downturns, reducing withdrawals can help preserve your capital.

• Alternative Income Sources: Consider having other income streams, such as part-time work or pensions, to reduce your reliance on your investment portfolio, especially during market downturns.

• Cash Reserve: Keep 2-3 years’ worth of living expenses in cash. This can help you avoid selling investments at a loss to meet living expenses during market downturns.

Common Mistakes and Considerations

While it's essential to be aware of SORR, there are a few common pitfalls to avoid:

• Overly Conservative Portfolios: In an effort to avoid sequence risk, some retirees may become too conservative, sacrificing potential growth. Balance is key.

• Ignoring Withdrawal Timing: Taking withdrawals during downturns can lock in losses. Be flexible with your withdrawal strategy.

• Longer Planning Horizons: The longer your retirement horizon, the greater your exposure to SORR. Planning for a longer-than-expected retirement can help mitigate this risk.

Bottom Line

Sequence of returns risk is a significant consideration in retirement planning that can’t be ignored. It emphasizes the importance of not just focusing on average returns but understanding how the timing of those returns can affect your financial future. By employing strategies like diversification, dynamic withdrawals, and alternative income sources, you can better shield your retirement savings from this risk. Ultimately, a well-thought-out and flexible financial plan can help ensure your retirement years are as secure and stress-free as possible.