One of the biggest risks to a successful retirement plan is sequence of returns risk. Also known as timing risk, sequence of returns risk is the potential for lower or negative returns during the initial period in which the investor makes withdrawals from a portfolio. If left undefended, sequence of returns risk can significantly affect the outcome of a retirement plan.
An Example of Sequence of Returns Risk
First, let’s understand what sequence of returns risk is. In the example below, we invest $100,000 each in two portfolios. In both portfolios, we withdraw $5,000 per year inflated at 3%. Both portfolios earn an average arithmetic return of 6.5% over the next 20 years. In Portfolio A, we see four years of initial negative returns and in Portfolio B, we see four years of initial positive returns. By year 20, Portfolio A has run out of money, while Portfolio B still has a balance of $87,054. (For more, see: Common Risks That Can Ruin Your Retirement.)
For a more extreme example of sequence of returns risk, let’s take a look at the two portfolios below. In this example, we have the same initial investments of $100,000 in both portfolios. We again withdraw $5,000 per year inflated at 3% from each and both portfolios earn an average arithmetic return of 6.5% over the next 20 years. In Portfolio A, we see all of the negative returns in the initial years. By year 11, Portfolio A has run out of money. In Portfolio B, we see the same returns reversed so all of the positive returns occur in the initial years. By year 20, the balance in Portfolio B has grown to $175,374.
As shown in the examples above, sequence of returns can have a major impact on portfolios that are otherwise very similar. The initial poor performance of the market forces us to withdraw from the principal in our portfolio, creating permanent losses. Despite a strong market later on, we are unable to make up those initial losses. Poor markets during the initial years of your retirement can create a drag on your portfolio that can be difficult to overcome. If you plan to retire and the market is in a slump, you may simply choose to continue working until the environment changes. That option may not be possible for those who have already retired and then see poor markets in the first years of retirement. (For related reading, see: 5 Crucial Tips for Your Retirement Income Planning.)
Strategies to Address Sequence Risk
There are many strategies to address this risk, but one of the most important is realizing if you plan far in enough in advance, you can significantly improve your chances of a successful retirement. Risk should be taken when you are younger and never in excess of what you are comfortable with. As you approach retirement, you should take less and less risk in the market. Do not let your retirement goals rely on rate of return, especially if that return is not appropriate for your age or risk tolerance.
Instead, focus on investing in multiple differentiated investment vehicles that diversify not just the type of investment but taxation as well. Establish a reliable source of income in all three classifications of taxation: income taxable, capital gains taxable and tax free. These steps could provide you with a greater opportunity to navigate sequence of returns risk.
The goal is to minimize risk while also providing yourself the opportunity needed to grow your wealth. Being knowledgeable about those risks and having a plan that addresses worst-case scenarios will lend to a stronger and steadier retirement plan. (For more from this author, see: Important Steps to Take for Your Retirement Plans.)
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