Sequence of Returns Risk: A Retirement Killer
For many, retirement is a time to unwind, rekindle relationships, discover new interests, and enjoy the fruits of a lifetime of labor. While retirement should mark a less stressful chapter in life, it’s important to remember that there are risks lurking in the background that could disrupt that peace. One such risk to be aware of is called sequence of returns risk, which can quickly and severely derail the success of almost anyone’s retirement without a proper plan to avert it. But what is sequence of returns risk, why is it so dangerous, and how can you prevent it from wreaking havoc on your retirement plans? Let’s find out.
What is Sequence of Returns Risk?
Sequence of returns risk refers to the risk that arises when you begin withdrawing money from your investment accounts, which if done incorrectly, could negatively impact your ability to cover your expenses throughout your retirement. Now, the vast majority of retirees will be pulling money out of their investment accounts to cover expenses – that’s the whole point of saving, right? But it’s not the withdrawals themselves that are problematic, it’s the timing of those withdrawals that is cause for concern. For example, if you need to withdraw a certain amount of money and experience a substantial market correction during that period, you will now have to sell more shares to generate the same amount of income. The result? You now have fewer shares growing your wealth and significantly less savings when the market eventually rebounds, making it much more difficult to cover your expenses throughout retirement. This is sequence of returns risk.
An Analogy To Explain This Concept
Imagine you live in a rural village without a centralized water supply system. Your only source of water is the rainwater you collect each year during your region’s rainy season, which must last you through the dry season, where it almost never rains. Now, imagine your rain collection system has a leak (i.e., a market correction). If this happens during the rainy season (i.e., before you retire), the problem is fixable. You will have lost some of your water supply, but you can simply patch the hole and collect more water until you’ve replenished your supply (i.e., continue to invest and wait until the market rebounds to retire).
Now, what if this happens during the dry season (i.e., during your retirement)? Well, your situation becomes more challenging. During the dry season, you have no way to refill your supply (i.e., you are no longer working and don’t have time to ride out a market correction), and you need to use your water supply (i.e., you need to withdraw money for your retirement expenses). Each time you use your water supply, you are now taking a larger and larger percentage of that supply, diminishing it quicker than you would have otherwise done had there not been a leak. By the end of the season, your water supply will be so strained that you may have to cut out less essential uses of water (i.e., cut back on your spending). This is sequence of returns risk at work.
A Hypothetical Case Study: The Great Recession of 2008
To illustrate this concept even further, let’s look at a sample investor at the beginning of the Great Recession. Imagine you retired in mid-2007 with $2 million invested in a portfolio with a similar risk profile to the S&P500. Based on your current budget, you determine that if you withdraw $25,000 quarterly from your account ($100,000 annually), adjusted for inflation, you will have enough money to cover your annual retirement expenses with a bit of money left over at the end of your life. However, shortly after you retire, we enter into the Great Recession, and over the next year and a half, your portfolio value drops by around 56% (S&P500 returns from Oct. 2007 – Mar. 2009). With those withdrawals still taking place, by the time the market fully recovers in March 2013, you would only have roughly $1.3M left in your investment account, a far cry from the $2 million you retired with. And let’s say you retired at 62 years old, now you’re looking at needing to stretch that $1.3M across the next 20-25 years while still requiring $100,000 per year to live, an amount that has and will continue to increase due to inflation. When you retired, you were likely feeling great about your financial position, but now, that peace of mind you once had is gone. This is why sequence of returns risk is so dangerous.
So, How Can You Protect Yourself?
The best way to protect yourself and your financial future from sequence of returns risk is through detailed financial planning and careful portfolio construction. Financial planning can help you identify any and all expenses you are likely to face during retirement, so you have a clear understanding of your income needs and won’t be hit with any surprises. Portfolio construction, on the other hand, can help you develop a portfolio that is able to generate income that is more resilient or even immune to the ebbs and flows of the market, so you aren’t forced to sell stock at a lower price.
If you’d like to learn more about how to protect yourself from sequence of returns risk, please click the link below to schedule a free consultation. Thank you for reading this month’s editorial article from “Wealth Watchers”. I hope you found it insightful!
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James. Prior to making any investment decision, you should consult with your financial advisor about your individual situation.
