The term “sequence of return risk” is often seen in online articles and frequently used by financial professionals, but what does it actually mean?
That’s kind of a mouthful. However, it’s actually a very simple concept. And this is important to understand for those who will need to draw from their savings to provide retirement income.
What is the definition of earnings sequence risk?
Let’s break it down. The dictionary defines it as:
A sequence is “a specific order in which related events, movements, or things follow one another.”
Return is the profit earned from an investment.
Risk is exposure to danger or loss.
In other words, sequence of return risk is a term that describes the risk associated with the timing of converting an investment into cash.
Here’s a simple way to understand it: Let’s say you withdraw money from your retirement fund each year to cover your expenses. If the stock market drops significantly the moment you start withdrawing, you could run into trouble. Even if the market eventually recovers, withdrawing funds during a recession can significantly shrink your portfolio. And with less money left in your account to benefit from market recovery, it’s harder to recover the value of your investments.
Return risk order and financial security
What risk of return really means is that timing is everything.
If you have to sell assets at a loss early in your retirement, you will be in a much worse situation than if you experienced the same losses later in life.
Withdrawing funds during market downturns can have a significant impact on future forecasts
Markets generally trend upward, but there are cyclical bull and bear markets that can last anywhere from one year to several years. These markets are very difficult to predict. However, the timing of negative returns can have a significant impact on your final nest egg.
For example, consider two investors who have saved $100,000 for retirement. Both withdraw $5,000 per year, experience % gains/losses in the same year, have the same average return, but in a different order.
Retiree A: Profits at the start of retirement
Retiree A notices that he initially makes a profit and then, after a number of years, incurs a loss. The annual rate of return for 15 years is as follows:
Retiree B sees these years in reverse order. First there are years of losses, followed by years of gains. The annual rate of return for 15 years is as follows:
Retirees A and Retirees B both have the same average rate of return
This gives you exactly the same average rate of return (4%) in all years.
Retiree A is much better than retiree B
Even with the same average interest rate, Retiree A had a much higher overall return than Retiree B.
Retiree A’s ending balance increased by $105,944 after 15 years. Retiree B ended up getting only $35,889.
This shows how much the first few years can make or break your retirement.
How do you protect against a range of return risks?
So how can you prevent this risk? Let’s consider your options.
Store 1-3 years worth of expenses in cash
First, it’s important to be conservative with your spending and manage your emergency fund in case of a downturn.
This includes flexibility in your spending and maintaining a lifestyle that allows you to quickly reduce your spending if needed.
Don’t have cash and need to withdraw it? Consider alternative funding sources
If your investments are down but you need access to funds, you may need to get creative. You want to have enough cash to cover your living expenses for one to three years so you don’t have to withdraw your investment at a loss.
Look into your emergency fund sources and consider side hustles, passive income, or additional work. Is it time to downsize and cash out your home equity? Consider ways to reduce your housing costs.
Allocate your assets wisely
It’s important to balance volatile and safe investments in your portfolio, and change that balance as needed. This means moving money away from risky companies and into the index when the market improves. Additionally, it is important to choose which investments to withdraw. By making strategic selections from your portfolio, you can minimize the impact of this risk.
Be flexible with your spending
Many retirees plan to withdraw a certain percentage from their accounts during their retirement.
However, you may want to adjust your withdrawal amount depending on your financial situation. if:
Stock prices are high and inflation is low so you can withdraw more
If markets are weak and inflation is high, you may want to reduce your distribution.
Consider securing the income you need
Finally, purchasing an annuity early in retirement can provide lifetime income to hedge this risk. We will discuss these in more detail in other articles.
Plan and monitor your financial health
Creating and monitoring a long-term financial plan is the key to financial health. A plan provides a roadmap to your financial life.
NewRetirement Planner provides a comprehensive framework for financial decision-making that goes far beyond saving and investing. Assess your set of return risks, find out how to save on taxes, and more.
Forbes magazine calls this a “new approach to planning.”
