Understanding the Sequence-of-Returns Risk and Why It Matters So Much
Friday, February 16, 2024
No one likes it when their investment portfolio takes a hit, but it’s even more of a concern when you are in or near retirement.
At issue, is the little known or discussed phenomenon known as the sequence-of-returns risk. The word sequence here refers to the fact that the order and timing of negative investment returns has the potential of having an out-sized impact on how long your retirement funds last.
The reason we invest our retirement funds in the first place is because we want to maintain our living standards long after we quit working and having earned income. Investing our money is what allows us to do that. In recent months, we’ve seen why! Because inflation will eat away at your purchasing power, and unless you are “invested” and your money is growing, each year your standard of living would go down.
Investing is important in order out pace inflation.
While investing allows us to grow our money as markets advance, we are all also very aware that sometimes markets go down and our investment returns are not as favorable in the short term. Market ups and downs are normal, but can be an even bigger concern when you are already drawing money out of your retirement funds for daily living expenses.
It’s vitally important that your distribution rate be lower than your investment return rate when annualized. If not, you could run into trouble. I liken managing a portfolio in retirement (or distribution phase) like filling up a bathtub with the drain open. As long as more water is coming out of the spout than going down the drain, the tub should stay full. But when the drain is allowing more water out than the spout can put in, that’s when the trouble arises.
Now, back to the sequence-of-returns risk and why it matters…
Two investors, invested in the exact same portfolio, can have dramatically different investment results depending on when the investments were made. A major drop in the early years of your retirement can scramble your retirement plans. When you start taking distributions from your portfolio as it’s losing value, you have to sell more investments to raise a set amount of cash. Not only does that drain your retirements funds more quickly, it also leaves you with fewer assets that can generate growth and returns during any potential market recovery.
For example, you have two investors who start with $1 million portfolios, take initial withdrawals of $50,000 (with 2% inflation adjustments each year after), but then experience a 15% drop in portfolio value. The investor who faces this sort of decline EARLY in retirement runs out of money far sooner than an investor who faces the same level of decline but later in their retirement years.
Chart Source: Schwab Center of Financial Research
For illustration purposes, each investor began with the same amount of money and reinvested dividends and interest. Each took an initial $50,000 withdrawal and increased their withdrawals by 2% on an annual basis to account for inflation.
Notice Investor 1’s portfolio experiences a 15% decline for the first two years of retirement and a 6% positive gain for years 3-18.
Investor 2’s portfolio assumes a 6% return for the first nine years, then a decline of 15% for years 10 and 11, and a 6% return for years 12-18.
The difference between the two portfolios is the timing of the market decline.
One can look at this chart and feel that because of possible loss, it would be best to reserve all our retirement funds in cash. However, while loss is possible in the market, keeping ALL our money in cash is a guaranteed loss as a result of inflation, or rather, the loss of purchasing power.
Investing is important to maintain our standard of living long after we stop receiving earned income. So what do we do to manage this sequence-of-investing risk?
1. Keep some money in reserve through short term liquid investments to satisfy distributions from your portfolio, such as money market funds. This way you can cover your monthly expenses without having to sell investments while they are down. This will allow those investments time to recover
2. Scale back when necessary. Anytime that market and/or your portfolio is under pressure (and they will be from time to time) it’s always a good idea to scale back on distributions if possible. Anything you can do to keep from having to sell investments while the market is down could potentially benefit your portfolio down the road.
Important to Note…
We might be tempted to think that a rebounding market should help us quickly make up any ground that was lost. Unfortunately however, this is not always the case. Continuing to take withdrawals can create strong headwinds for your portfolio. But given the fact that many depend on withdrawals for living, moving more cautiously becomes that much more important in navigating through volatile market cycles.
Blessings--
Jim
(The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.)
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