Beware retirement’s overlooked risk: Sequence of returns

This article will ... Define what sequence of returns risk is and why it often gets overlooked. Use two hypothetical examples to demonstrate the math behind the risk. JReview strategies that can help mitigate sequence of returns risk.

As Mike Tyson once famously said, “Everyone has a plan till they get punched in the mouth.” The recent market volatility is a stern reminder for retirees of just how important it is to have a plan. It is also a reminder that when it comes to retirement income planning specifically, timing is everything, which is why it is important to understand what financial professionals refer to as “sequence risk” or “sequence of returns risk.”

Every day, more than 10,000 individuals retire in the United States. Most people no longer have pensions to rely on and will only have Social Security for guaranteed or reliable income, and so they will need to rely on their assets to generate income.

But as people live longer, not only do they risk outliving their money, they will also encounter sequence of returns risk — the order of an investor’s investment returns.

A stealthy problem

Sequence of returns risk is often an overlooked and misunderstood problem for retirees. And yet, perhaps more than anything else, sequence of returns risk can make or break your retirement nest egg.

What exactly is sequence of returns risk? It is a risk that applies to individuals closing in on retirement or already in retirement who need to withdraw assets each year from their portfolio to generate retirement income. (Related: Determining your ideal retirement withdrawal rate)

For these individuals, the order (or sequence) of the returns each year on their portfolio can actually be far more important than the returns themselves. In short, experiencing one or two years of negative returns early on in retirement can have a significant and damaging impact on how the rest of your retirement plays out.

Understanding the math

Let’s look at a really simple example. Consider two individuals, Mary and Bob.

In the first chart, Mary and Bob are still accumulating assets for retirement and investing for growth. Mary’s returns start off strong, but, at the end of the 10-year period, she experiences a bear market and loses 20 percent and 25 percent in years 9 and 10, respectively. However, over the full 10-year period, she still earns an average annual return of 4.23 percent.

Bob’s annual returns are the same as Mary’s, but reversed. So, the major negative returns (-25 percent and -20 percent) come in the first two years instead of the last two years. Bob, of course, also earns an average annual return of 4.23 percent and both individuals end up with $1,578,100 after 10 years.

	Mary	Annual Return	Bob	Annual Return
Beginning Value	$1,000,000	28%	$1,000,000	-25%
Year 1	$1,280,000	25%	$750,000	-20%
Year 2	$1,600,000	9%	$600,000	12%
Year 3	$1,744,000	14%	$672,000	8%
Year 4	$1,988,160	12%	$725,760	5%
Year 5	$2,226,739	-7%	$762,048	-7%
Year 6	$2,070,867	5%	$708,705	12%
Year 7	$2,174,411	8%	$793,749	14%
Year 8	$2,348,364	12%	$904,874	9%
Year 9	$2,630,167	-20%	$986,313	25%
Year 10	$2,104.134	-25%	$1,232,891	28%
End Value	$1,578,100	4.23%	$1,578,100	4.23%

Now let’s look at the scenario differently, with just one small change. In the chart below, we assume Mary and Bob have just retired and plan to draw 5 percent or $50,000 per year from their $1,000,000 portfolios. Mary and Bob experience the same returns as outlined above. While they both experienced the same average annual rate of return of 4.23 percent and they employed the exact same strategy, their actual results were significantly different.

Mary ends the 10-year period with a balance of over $ 1.1 million, while Bob’s balance is down to almost $500,000. Unfortunately for Bob, he starts to draw income just before a significant bear market and his portfolio is unable to recover, putting him at risk of potentially running out of money much sooner than expected.

	Mary	Annual Return	Bob	Annual Return
Beginning Value	$1,000,000	28%	$1,000,000	-25%
Year 1	$1,230,000	25%	$700,000	-20%
Year 2	$1,487,500	9%	$510,000	12%
Year 3	$1,571,375	14%	$521,200	8%
Year 4	$1,741,368	12%	$512,896	5%
Year 5	$1,900,332	-7%	$488,541	-7%
Year 6	$1,717,308	5%	$404,343	12%
Year 7	$1,753,174	8%	$402,864	14%
Year 8	$1,843,428	12%	$409,265	9%
Year 9	$2,014,639	-20%	$396,099	25%
Year 10	$1,561,711	-25%	$445,124	28%
End Value	$1,121,283	4.23%	$519,758	4.23%

As these charts indicate, sequence of returns really does matter. When investors are drawing money from their portfolios, the order in which they experience gains and losses is often more important than the gains and losses themselves.

The recent market volatility and uncertainty due to COVID-19 is a compelling reminder that generating retirement income from your assets can be precarious and requires careful planning.

This video highlights just how impactful timing and sequence of returns can be to a retirement income plan.

The example in the video uses real historical returns. Both individuals employ the identical strategy of withdrawing 4 percent annually from their assets, and they increase those withdrawals slightly each year to adjust for inflation.

In one scenario, the returns in the video go back to 1979 and demonstrate what their income and asset values would look like over a potential 30-year retirement. In the second scenario, the returns are reversed, starting with 2009 and working backwards. In both cases, the actual average annual rate of return was 9 percent, but, as you will see, their outcomes are dramatically different.

Retirement planning is often compared to climbing a mountain. While getting to the top of the mountain can be a great challenge, often getting back down is even more dangerous, with less margin for error. Similarly, when it comes to retirement planning, one could argue that growing your nest egg and getting to retirement is the easy part, while actually spending those assets in retirement is wrought with challenges.

Strategies

During our retirement years, not only do we still need to contend with a volatile stock market and make sure we keep up with inflation, but we now confront additional challenges, such as longevity and sequence of returns.

But many people do not have a plan to absorb sequence of returns risk. Yet there are a myriad of strategies that can help.

Some individuals utilize products that provide guaranteed lifetime income. For example, they may use income annuities to guarantee some or all of their essential expenses, providing peace of mind that their basic needs will be covered regardless of market volatility. (Related: Does an annuity fit your retirement goals?)
Others employ a “buffer” strategy, ensuring that they have safe assets with a minimum of 2- or 3-years’ worth of income that can be utilized when the rest of their portfolio is otherwise down. (Related: How life insurance can help you in retirement)
Yet another option is that individuals can employ a flexible lifestyle approach and plan to spend less during market declines. (Related: Downsizing in retirement)

Each of these approaches come with their own advantages and disadvantages. Planning for income in retirement is not a one-size-fits-all solution. Each individual’s needs and objectives are unique and different. Many people consult a financial professional for advice on which strategy may be best.