How Sequence of Returns Risk Could Impact You, Ep #89

Most people know little to nothing about sequence of returns risk. The subject doesn’t make for the most interesting topic for cocktail party discussions.

Even though, some refer to it as your biggest retirement risk.

Reason being, sequence of returns risk can have a major impact on how long your hard-earned savings will last through retirement. This week’s episode we dive in to examples of how you could be affected and steps you could use to fight against it.

Market returns in your first few years of retirement can have a significant impact on your long-term wealth.

While it is true that despite market volatility, stocks provide higher rates of return over the long term on average, the order of those returns matters a lot. Consider the following scenario:

An example of sequence of returns risk

Let’s consider a couple that is 60 years old with a million dollars who just retired. In the first example, they earn 8% each year over the next 30 years. They withdraw a little over 6% of the portfolio balance each year, and 30 years later, they’ve spent their entire portfolio as they had planned.

The second example takes the same couple but rather than earning 8% each year, they had great returns of 20% for the first 2 years, and 0% in next 2 years. This scenario left the couple with a million dollars at the end of 30 years.

The last scenario has the same couple’s experience but in reverse the first 4 years. A bad market the first few years (0% for first 2 years), then 20% returns the next two years. This scenario leads the couple to run out of money in year 24.

All of these examples had the same average return and withdrawal amounts, but the end results were drastically different. The first few years have an enormous impact on your long term success.

Why did Chad and Mike end up with different balances at the end of their careers?

Now let’s look at this concept from the saver perspective. Chad and Mike begin working at 25 years old and continue to work for 40 years. During this time, they maintain the same income and save the same amount each year. They both earned an average of 8% a year. Only differences, is their age, so they began working on different dates and retired at different times.

Unfortunately, Mike experienced poor returns the last 10 years before retirement. In contrast, Chad had poor returns when he was just starting out and favorable returns the 10 years prior to retirement. So Chad experienced a good sequence of returns and Mike received a bad sequence of returns before retiring. This resulted in a $300,000 difference between Chad and Mike’s final balance.

The lesson here is when you’re younger, your balance isn’t that big so how the market performs doesn’t matter as much. When you are older, the timing of returns is much more important. Because it doesn’t matter if returns average out in the long run if you don’t have any money left when the good returns show up. What is a retiree to do?

What strategies can you implement to protect yourself from the sequence of returns risk?

Diversification is important. Assure you are implementing a globally diversified portfolio. U.S. stocks, international stocks, large and small cap investments.
Consider your asset allocation. The time right before and right after you retire is not a time to take on a lot of stock risk.
Be flexible with your spending based on portfolio performance. Creating a financial plan provides helpful targets here. Monte Carlo Analysis helps determine the viability of your retirement income strategy and put guardrails in place to make adjustments in the event of bad market conditions. You may decide to start with a low withdrawal rate, but ratchet higher over time. You can also start with a higher withdrawal rate as long as you are willing to adjust down if necessary. Essentially slowing withdrawals to allow your portfolio to recover from market losses while increasing equity allocations to take advantage of higher future return potential.
Adjust the amount of stock you own based on market valuations. If the market is expensive you should own less in stocks, if the market is cheap you can own more. This takes continual monitoring and long potential periods of underperformance.
Don’t get nervous and shift to cash and bonds. Stocks are a good hedge against rising costs of inflation. Remember that people are living longer, you may need that money to stretch farther than you thought. Having a guide to talk through fearful knee-jerk decisions can be monumentally comforting.

Outline of This Episode

[4:27] What constitutes good or bad returns?
[8:56] The first few years have a big impact on your long term success
[11:15] Why did Chad and Mike end up with different balances at the end of their careers?
[14:23] What strategies can you implement to protect yourself from the sequence of returns risk?