Editor's Note: This story originally appeared on NewRetirement.
“Sequence of returns risk” is a phrase you’ll see in online articles and thrown around by financial pundits, but what does it really mean?
It is kind of a mouthful. However, it is actually a fairly simple concept and one that is important to understand for anyone who will be requiring withdrawals from savings to contribute to their retirement income.
What Is the Definition of Sequence of Returns Risk?
Let’s break it down. The dictionary defines:
- Sequence as “a particular order in which related events, movements, or things follow each other.”
- Returns as your profits from investments.
- Risk as your exposure to danger or loss.
So, sequence of returns risk is a phrase that describes the risk associated with the timing of cashing out your investments.
Okay, but What Does Sequence of Returns Risk Mean for Your Financial Security?
What sequence of returns risk really means is that timing is everything.
If you have to sell assets at a loss early on in your retirement, you are much worse off than if you experienced the same loss later in your life.
This is an especially important idea to consider now, as markets threaten to enter a period of uncertainty following the pandemic and as uncertainty mounts with the war in Ukraine. Individuals who have recently retired, are in the process of retiring, or plan on entering retirement soon need to understand the ramifications of making withdrawals from invested assets while the markets are down.
Withdrawing Money When the Market Is Down Can Have a Huge Impact on Future Projections
While the market generally trends upward, we experience cyclical bull and bear markets that can be anywhere from one to many years. It’s extremely difficult to predict these markets. However, the timing of negative returns can have a huge impact on your ultimate nest egg.
Take for example, two investors who each have saved $100,000 for retirement. Both withdraw $5,000 a year and both experience the same years of percentage gain/losses, with the same average return, but in a different order.
Retiree A: Gains at the start of retirement
Retiree A sees the gain years in the beginning, and loss years later on. Their annual rate of return across 15 years is as follows:
8%, 11%, 18%, 14%, 12%, 9%, 11%, 9%, 7%, 5%, -4%, -15%, -6%, -5%
Retiree B: Losses at the start of retirement
Retiree B sees these years in the reverse order, with the loss years in the beginning and the gain years later on. Their annual rate of return across 15 years is as follows:
-5%, -6%, -15%-4%,, 5%, 7%, 9%, 11%, 9%,, 12%, 14%, 18%, 11%, 8%
Both Retiree A and B Have the Same Average Rate of Return
This results in the same exact average rate of return across all years — 4%.
Retiree A (Gains at the Start of Retirement) Does Much Better Than Retiree B (Gains at End of Retirement)
Even though their average interest rate is the same, Retiree A saw a much higher overall return than Retiree B.
- Retiree A’s ending balance was $105,944 higher after 15 years. Retiree B only ended up with $35,889.
This demonstrates how powerful these first few years can be to either help or hurt your retirement.
How Do You Defend Against Sequence of Returns Risk?
So, how can you defend against this risk? Let’s explore your options.
Maintain 1-3 Years of Expenses in Cash
Firstly, it’s important to spend conservatively and manage emergency funds in case you do experience a downturn.
This can also encompass spending flexibility — or maintaining a lifestyle that allows you to quickly reduce your spending if needed.
Don’t Have Cash and Need to Withdraw? Consider Alternative Sources of Money
If your investments are down but you need access to money, it may behoove you to get creative. You want to have adequate cash available to cover one to three years of living expenses so you don’t need to withdraw from investments at a loss.
Explore sources of emergency money and consider side gigs, passive income, or additional work. Is it time to cash out on home equity by downsizing your home? Look at ways to cut housing costs.
Be Smart About Your Asset Allocation
It’s important to balance your portfolio with volatile versus safe investments and to change that balance as needed. This can mean shifting your funds out of risky companies and into an index when the market turns. Additionally, it’s important to choose which investments to draw down. Selecting strategically from your portfolio can minimize the impact of this risk.
Be Flexible With Your Spending
Many retirees plan to withdraw a fixed percentage from their accounts throughout their retirement.
However, it may be a better idea to adjust your withdrawals depending on economic conditions:
- If stocks are high and inflation is low, you can withdraw more.
- If the market is down and inflation is high, then you will want to distribute less.
Consider Guaranteeing Required Income
Finally, annuities can provide lifetime income to hedge against this risk if purchased earlier in retirement. These are explored more in-depth in our other articles.