Whenever I’m teaching a class on building solid financial systems for retirement, I’ll ask if anyone has heard of sequence of returns risk. Typically, no more than one hand in the room will go up. It’s alarming how few are familiar with this principle. And yet sequence of returns risk is perhaps the greatest threat most retirees will face – without even realizing they will face it.
So what is sequence of returns risk? Here’s how Investopedia defines it…
“[T]he risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments. The order of the sequence of investment returns is a primary concern for retirees who are living off the income and capital of their investments.”
I know it sounds complicated, but we’ll break sequence of returns risk down with an easy-to-follow example.
Okay, let’s say you’ve invested $100,000 in a hypothetical stock called XYZ. I want to keep this simple, so we’re going to ignore any taxes and fees on this investment and focus instead on how the sequence of returns risk works.
Now, let’s say your investment earns 50% in the first year. Your investment in XYZ is now $150,000. In the second year, however, let’s say you lose 50%. Your investment has now dropped to $75,000.
Easy enough, right? Good. Let’s reverse the order now. Let’s say you lose 50% in your first year, which means your investment in XYZ dropped from $100,000 to $50,000. In the second year, your investment gains 50%, and the value of your holdings in XYZ are now $75,000.
See? It doesn’t matter which order those rates of return occurred – after the second year, the value of the investment is $75,000 in both cases.
Let’s complicate the situation just a little. Now we’re going to assume you need to withdraw from your investment for retirement income. Again, I’ll try to keep this simple.
Back in the first example, we held $150,000 in XYZ after the first year. This time, we’re going to withdraw $10,000 for income, leaving us with $140,000 invested. In the second year, we lose 50% and are down to $70,000. We again withdraw our $10,000 for income, and our nest egg is now $60,000.
That wasn’t too difficult. But let’s see what happens when we reverse the order this time.
In the second example, our investment in XYZ had lost 50% and was down to $50,000. When we withdraw our $10,000 for income, we are left with $40,000. In the second year, though, we gain 50%, and so our investment in XYZ grows to $60,000. But when we withdraw another $10,000 for income, we have only $50,000 remaining.
$60,000 vs. $50,000 – suddenly, the order in which the rates of return occurred makes a difference.
Okay. Let’s apply this to a more realistic example, now. We’ll say John has retired at 65 years of age with a $1 million portfolio. In his first year, John will take $50,000 for income and then increase that amount by 3.5% for inflation each year thereafter.
We are going to consider two scenarios for John’s retirement. In the first, John will experience rates of return that are higher early in his retirement… 27%, 9%, 7%, -15%, and so on repeating this sequence until he has run out of money.
In the second scenario, we will reverse the sequence of returns: -15%, 7%, 9%, 27%, and again repeating the sequence until John has run out of money.
As you can see, the sequence of returns makes a huge difference. In the first scenario, John’s retirement savings lasts 37 years. In the second, he depletes his savings in only 24 years. Keep in mind, too, that a 15% loss isn’t exactly significant – at least, not compared to the 25-50% losses many experienced back in 2008.
That’s sequence of returns risk. If you’re one of the many who have never heard of it, though, don’t be hard on yourself. We are conditioned to believe it doesn’t matter which order the rates of return occur. Why? Because we spend most of our lives accumulating our wealth with a long-term mindset, and, if we are investing a lump sum, the order in which gains and losses occur is irrelevant.
In fact, during the accumulation stage of life, losses can provide opportunities. If you are saving for retirement with a 401(k) plan, for example, a drop in investment value allows you to purchase more shares at a discount. And that can be a real long-term advantage if and when the investments increase value.
We call this dollar-cost averaging. While it can be a good thing earlier in life, when we begin drawing an income from our savings, it works against you – we call that reverse dollar-cost averaging. And that is why sequence of returns risk is such an important factor in retirement.
When financial markets are doing well, sequence of returns risk really isn’t that big of a deal. If you look back at the period between August 12, 1982 to January 14, 2000, the Dow Jones rose more than 1,500%. That’s astonishing! This was the most incredible bull market any of us had ever seen – perhaps the greatest my children will ever see, too… and they aren’t even born yet! So, if you had retired early in this period, sequence of returns risk would probably have not concerned you.
However, if you had retired near the end of that period, around the beginning of the dotcom crash, sequence of returns risk might have made a tremendous difference in how long your money would last.
So, I believe it’s absolutely critical to protect yourself from large stock market losses especially in the period from about 5 years before retirement until at least 5-7 years after retirement.
Why? Historically, bull markets last an average 5.5 years. Our current bull market will turn 7.5 years old this month. While some financial analysts believe the significant downturn in 2008 and 2009 created conditions for this longer-than-average bull market we now enjoy, I can’t tell you when it will end or when the next bull market will begin. What I can tell you is that if you are recently retired or planning to retire soon, you need a strategy in place to help minimize and perhaps even eliminate this risk.
This is one area in which you really need to consult a financial advisor that specializes in retirement income planning.