Sequence Of Returns Risk

Sequence of returns risk refers to the potential negative impact on your retirement savings caused by the order in which your investment returns occur. This risk is particularly critical for retirees who rely on their investment portfolio for income. For instance, if you experience a market downturn early in your retirement, say a 20% drop in your investment value, you might be forced to withdraw funds at a loss, which can deplete your savings faster than if you had favorable returns in the early years. Conversely, if you had strong returns initially, your portfolio might sustain withdrawals better over time.

To illustrate, consider a retiree with a $1 million portfolio who withdraws $40,000 annually. If the first year sees a 20% market drop, the portfolio value would decrease to $800,000. In contrast, if the market were to rise 20% in the first year instead, the portfolio would grow to $1.2 million, providing more cushion for future withdrawals. The sequence of returns can thus drastically alter financial security over a 30-year retirement.

A common misconception is that average returns are all that matter; however, the order of those returns plays a crucial role in portfolio longevity. Many retirees mistakenly believe that if their investments average a return of 6% over time, they will be fine, regardless of market fluctuations. This is not necessarily true. A poor return in the initial years can lead to a higher risk of running out of money, even with seemingly adequate average returns.

The key takeaway is to account for sequence of returns risk in your retirement planning. Consider strategies like maintaining a cash reserve, diversifying your investments, or utilizing annuities to reduce reliance on market performance for early withdrawals. This proactive approach can help ensure your savings last throughout your retirement, regardless of market conditions.