So, what is Sequence of Returns Risk? It is the danger retirees face of receiving lower or negative returns early in retirement when withdrawals are made from their underlying investment accounts. Savvy investors planning their retirement have to understand that there is risk in the order in which investment returns occur for those that are nearing, or in, retirement.
All Retirements are Not the Same
Two retirees with identical wealth can have entirely different financial outcomes, depending on when they start retirement. A retiree starting out at the bottom of a bear market will have better investing success in retirement than another starting out at a market peak, even if the long-term averages are the same.
In short, it has to be understood that it is not just the average returns on your investments in retirement, but the timing of those returns which is important. When you begin withdrawing money from your retirement accounts, the returns during the first few years can have a major impact on ensuring you do not run out of money and any money you plan to pass along as an inheritance.
This phenomenon can be viewed and understood in a couple of different ways. The first article [John Hancock] illustrates different potential outcomes when two retirees retire ten years apart when all else (e.g. portfolio value, rate of return, etc.) is equal. The second article [BlueCreek Investment Partners] illustrates a possibility when all factors are the same, except in this case the rates of return are identical, just flipped over a 15-year period. So, what does it mean now that you are aware of this phenomenon and you ponder your own retirement?
I believe there are two actions a savvy investor can take to avoid an unpleasant surprise halfway through retirement. First, have a well thought out withdrawal plan that considers the order of withdrawals from various types of accounts (e.g. taxable, tax-deferred or tax-exempt) and the tax implications of each. Second, be keenly aware of the rates of return during the first five years in retirement.
As both examples illustrate, low (or negative) returns during the early years of retirement can wreak havoc. This is where continually tracking and adjusting your retirement portfolio is a must. It isn’t enough to manage and track during the years leading into retirement. If, during the first few years in retirement, you see that the rate of return on your investments cannot support your spending rate over another 20 – 25 more years, you need to be ready to make the necessary adjustments, namely reducing spending and consider modifying your asset allocation.