Sequence of Returns Risk

Sequence of returns risk is a risk for retirees that’s not well understood. This is the risk of retiring into a market crash when taking income out of your portfolio and the devastating impact that it can have on your nest egg as far as being able to sustain income for rest of your life.

One of the challenges of determining “reasonable” spending in retirement is that, even if you are correct about the anticipated long-term returns of the retirement portfolio, there’s a risk that ongoing withdrawals right before a series of early bad returns may cause the portfolio to be fully depleted before the good returns finally arrive to average out in the long run.

This is very important for those of you out there that are just about to retire. If you are following the buy and hold method of investing and you ride a market crash all the way down at the beginning of retirement, it can have very bad results. Much worse than if that market crash happened later in retirement and not at the beginning.

When you are saving for retirement and not taking income out, negative returns impact you differently than when you are retired and taking income out of your portfolio. When taking income out, you play by a different set of rules and the timing of when those bad returns happen, can have very big implications on the sustainability of a portfolio to grow and provide income. Let’s look at 2 different people for example. Investor A vs. Investor B. Both investors retire at age of 65 with $500,000 and start taking out 5% per year which is $25,000/year. Let’s say they both also experience

similar performance numbers over a 17-year period with one big exception. Investor A started off with a market crash right when he retired while investor B had a market crash at the end of his retirement, not at the beginning.

To keep this simple, we’ll show investor A putting the $500,000 in the S&P 500 on January 1st, 2000 and taking 5% a year to live on. He completely ran out of money by the end of 2017. To keep the average returns the same, we’ll use the same yearly returns as investor A, but reverse the order so investor B will experience more of the better returns at the beginning. By the end of the same 17-year period, investor B still had approximately $500,000, while Investor A was completely out of money.

This shows the devastating impact of retiring at the beginning of a market crash. That’s why in our opinion, you should not follow the buy and hold method of investing when you are in retirement. It’s exposing you to too much risk and can dramatically affect your portfolio’s ability to provide income for the rest of your life.

The reality is that we do not know what the future holds, and we’re not aware ahead of time what type of economic environment we are going to retire into, either now or in the future. The remedy is to have a sell discipline to protect against market crashes, especially if you are approaching retirement soon when your hard-earned retirement assets are most exposed to this sequence of returns risk.

That’s the value a tactical investment strategy like the one we manage for our clients can offer. By having a sell discipline to reduce the stock exposure when risk in the market gets high, it helps minimize how much a portfolio can drop in severe market downturns.

Then when the market starts recovering, the money you didn’t lose can also compound and grow. This dramatically reduces your exposure to this sequence of returns risk, not only in early retirement when the risk is the greatest, but also later into retirement with future market downturns.