Good morning,
Retirement means different things to different people – stopping work to relax, or to play hard, finding satisfaction from volunteering, or leaving work to care for a loved one, are just some examples. Whatever the case, retirement comes with multiple risks, including market risk, inflation risk, healthcare risk, long-term care risk, longevity risk (the risk of outliving your money), and sequence risk, which is often the most overlooked, and the topic of our discussion here.
Sequence risk, also known as sequence-of-returns risk, refers to the possibility that low or negative investment returns during the first several years of retirement (if withdrawals are being made) can severely impact the likelihood of a portfolio successfully providing expected income throughout one’s lifetime. If an investor is neither adding to or subtracting from a portfolio, the order of returns has no effect on the final balance!
For example, consider a $1,000,000 portfolio, with sequential returns of -50% and +100%, it finishes with a balance of $1,000,000. If the order of returns was reversed, and returns were now +100% followed by -50%, it still ends with the same $1,000,000 balance. However, once withdrawals begin, the portfolio becomes affected by the change in the sequence of returns – the order of returns now matter – sequence risk.
Continuing with the same simple (and extreme) example, let’s consider a retiree who needs to withdrawal 500k at the end of the first year for expenses. Taking the “good” sequence the portfolio grows from 1 million to 2 million, the retiree takes out 500k, resulting in a balance of 1.5 million, then after a drop of 50% the following year, the portfolio value is 750k. With the “bad” sequence of returns, the portfolio declines from 1 million to 500k, and when the retiree needs to pull out 500k for expenses, the portfolio balance is now at zero, with nothing available to benefit from the +100% year.
While this is a hypothetical example, it’s to illustrate the point – if a high proportion of negative returns occur early in retirement, this has a negative impact and reduces the amount of income one could withdraw over his or her lifetime – when a retiree needs to sell investments to meet expenses during down markets, it reduces the amount of funds available to benefit from later occurring up years. Put another way, removing assets from a portfolio after a downturn basically locks in a loss, reducing the chance the overall portfolio will fully recover during the next upturn. A retiree (or investor) may find the portfolio cannot then provide the needed lifetime income, because of its now smaller size.
For a retiree who can meet his or her income needs through things such as pensions, social security, and cash, sequence risk is not a concern. But most individuals, in a world where pensions are harder and harder to come by, will need to rely in large part on the income and capital of their investments (such as 401k’s and IRA’s) to fund retirement. Trying to maintain a fixed standard of living taking distributions from a portfolio of volatile assets is an inefficient strategy for producing retirement income. Sequence risk should not only be considered, but managed and planned for.
Ways to combat sequence risk include: forecasting some “worst-case” scenarios so that an unfavorable sequence is built into a “stress-tested” model and planned for; withdrawing a fixed percentage of a portfolio each year, instead of a fixed dollar amount; owning non-correlated assets, so that one asset class might do well when others fall; utilizing annuities to provide income; building a bond-ladder so that some bonds mature each year to meet income needs; reducing portfolio risk before retirement; being able to avoid large withdrawals during market downturns by having a cash reserve to fund expenses; and having spending flexibility, being able to cut expenses during market downturns.
Of course, things could go the other way as well, and the first several years of retirement could be during a Bull Market, which would work in a retiree’s favor. Either way, whatever order the sequence may be, the ultimate goal is for a fulfilling and prosperous retirement!
All the best,
Southport Station Financial Management, LLC