Planning for a secure financial future is a lifelong journey, and one of the most substantive challenges you’ll encounter along the way is Sequence of Returns Risk. This often-overlooked yet profoundly impactful nuance of investing and retirement planning can make or break your financial dreams, especially if you are a victim of bad timing.
In this blog post, we will unravel the theory behind Sequence of Returns Risk, its critical significance, and strategies to mitigate its potential adverse effects on your financial well-being.
Section 1: The Theory of Sequence of Returns Risk
Understanding Sequence of Returns Risk
Sequence of Returns Risk refers to the order in which investment returns occur over time.
It is the risk that poor investment performance in the early years of retirement, compounded with consistent monthly account withdrawals, can substantially deplete your portfolio and jeopardize your financial security, even if long-term average returns are favorable.
The Mechanism of Sequence of Returns Risk
Imagine two individuals with identical average annual returns on their investments. However, if one experiences poor returns during the early years of retirement, they may need to withdraw a higher percentage of their portfolio to cover living expenses. This increased withdrawal rate can lead to a downward spiral, depleting their portfolio much faster than expected.
Why Sequence of Returns Risk Matters
Sequence of Returns Risk challenges the conventional wisdom of simply relying on average returns. It highlights the importance of not just how much you earn in the long run, but when you earn it.
Understanding this risk is crucial for anyone planning their financial future, especially retirees who rely on their portfolios to sustain their lifestyle.
Section 2: The Significance of Sequence of Returns Risk
Impact on Retirement Planning
For retirees or those nearing retirement, Sequence of Returns Risk is particularly significant. It can determine whether your retirement savings will last as long as you need them to, or if you’ll run out of money prematurely.
Long-Term Portfolio Sustainability
Sequence of Returns Risk can have lasting consequences on the sustainability of your investment portfolio. A poor sequence of returns early in retirement can accelerate the depletion of your assets, leaving you with inadequate resources in the later years of your life.
Psychological Impact
The psychological impact of Sequence of Returns Risk cannot be underestimated. Seeing your portfolio decline during the early years of retirement can lead to anxiety, stress, and potentially poor financial decisions, such as panic selling during market downturns.
Section 3: Factors That Influence Sequence of Returns Risk
Portfolio Allocation
The allocation of your investments across different asset classes, such as stocks, bonds, and real estate, plays a crucial role in determining your exposure to Sequence of Returns Risk. A portfolio heavily weighted in equities may be more susceptible to market volatility.
Timing of Retirement
The timing of your retirement relative to market conditions can have a substantial impact. Retiring during a bear market or just before a significant market downturn can expose you to more substantial sequence risk.
Withdrawal Rate
The rate at which you withdraw funds from your portfolio is a significant factor. A higher withdrawal rate increases the risk of depleting your assets prematurely, especially during periods of poor market performance.
Section 4: Strategies to Mitigate Sequence of Returns Risk
Diversification
A well-diversified portfolio can help mitigate the impact of poor returns in any single asset class. Diversification spreads risk and can make your portfolio more resilient to market fluctuations.
Asset Allocation
Choosing an asset allocation strategy that balances risk and reward is essential. This involves selecting the right mix of asset classes based on your risk tolerance and financial goals.
Dynamic Withdrawal Strategies
Adopting dynamic withdrawal strategies, such as the “floor and ceiling” approach, can help protect your portfolio during market downturns.
The floor and ceiling strategy allows greater spending when markets are up and requires spending reduction when they are down but with hard percentages set for both the ceiling and floor.
Delaying Retirement
Postponing retirement by a few years can reduce the impact of Sequence of Returns Risk. It allows your portfolio more time to recover from potential market downturns before you start withdrawing funds. Or if retirement isn’t delayed in its entirety, a reduced annual withdrawal amount supplemented with a part-time job to bring in some level of income can offset what otherwise would be a full withdrawal hit to the retirement account.
Section 5: Real-Life Examples
The 2008 Financial Crisis
The 2008 financial crisis serves as a stark example of Sequence of Returns Risk. Retirees who experienced significant market losses in the years leading up to or during their retirement faced considerable challenges in maintaining their financial security.
To add to the impact of the downturn in the market, retirees still had to withdraw their monthly living funds from their accounts creating a compounded hit to their retirement account balances.
For example, assume during a 5-year period the stock market declines 15% each year at the same time an individual abides by a standard withdrawal strategy recommended by the Trinity Study https://thefinancialstoic.com/what-is-the-trinity-study/ of a 4% annual withdrawal. The result is an annual net negative 19% of the retirees retirement account portfolio each of those separate years for 5 years.
The full extent of this combination of bad timing and a sustained market decline, even just over 5 years, could be catastrophic financially should the market take another few years to record positive gains in light of a continued annual withdrawal of 4%.
The Importance of Diversification
Diversification is particularly important to someone in retirement. Not only does a retiree need to rely on their retirement account to at least outpace their 4% annual withdrawal rate in order to maintain a consistent balance, they also can’t be susceptible to large value swings in their account.
To that end, most retirees would be completely happy with simply making more than what they withdraw annually and see no fluctuation in their account except for the slight increase in value needed to offset the reduction.
Conclusion
Sequence of Returns Risk is an important element in the landscape of financial planning, especially for retirees.
Understanding its significance and implementing strategies to mitigate it is essential for achieving your financial goals and ensuring a secure and comfortable retirement.
In order to ensure a viable long-term retirement, planning for fluctuations in the market must be taken into consideration prior to actually retiring.
In addition, having income generating assets that react differently than one another during general market operations, such as stocks and bonds, must be considered when going into retirement in order to sustain a comfortable retirement account balance and to mitigate the Sequence of Returns Risk.
