Sequence of Returns Risk: A Retirement Saver’s Hidden Threat

Sequence of returns risk is a critical concept for anyone saving for retirement, yet it’s often overlooked. It essentially refers to the danger that the order in which your investment returns occur can significantly impact your retirement savings, especially as you approach and enter retirement. It’s not just about the average return you earn over time, but when you experience those gains and losses that truly matters.

To understand this, consider two hypothetical investors, both aiming for retirement with a 30-year savings horizon and identical average annual returns of 7%. Let’s say Investor A experiences strong returns early in their saving journey, followed by weaker returns later. Investor B, on the other hand, experiences weaker returns initially and stronger returns in the latter part of their saving period. Even though both achieve the same average return, their retirement outcomes can be vastly different.

Why? Because of compounding and the power of starting early. When you earn strong returns early on, your initial investments grow significantly. This larger base then benefits from compounding over the remaining years, even if subsequent returns are less impressive. Conversely, if returns are poor in the early years, the base for compounding remains smaller, hindering overall growth even if later returns are excellent.

The sequence of returns risk becomes particularly acute as you near and enter retirement, during what’s often called the “withdrawal phase.” This is when you transition from contributing to your retirement accounts to drawing income from them. Imagine two retirees, both with the same initial retirement savings and needing to withdraw the same amount each year. Retiree 1 experiences a series of negative returns early in retirement, while Retiree 2 experiences positive returns in the initial years.

If Retiree 1 encounters poor market performance early in retirement, they are forced to sell investments at lower prices to meet their withdrawal needs. This not only depletes their capital faster, but also reduces their portfolio’s ability to recover when markets eventually rebound. Essentially, they are locking in losses and diminishing their future earning potential. This is often referred to as “selling low.”

Retiree 2, experiencing positive returns early on, can withdraw funds while their portfolio continues to grow or at least maintain its value. They are less likely to deplete their savings prematurely, even with identical withdrawal rates. They have the benefit of “selling high” or at least not being forced to sell low during market downturns.

This risk is amplified by the fact that market downturns are unpredictable. You can’t perfectly time the market, and a series of negative returns can occur at any point, including right before or at the beginning of your retirement. Such unfortunate timing can severely derail even the most carefully laid retirement plans.

So, how can you mitigate sequence of returns risk? While you can’t eliminate market volatility entirely, several strategies can help:

• Diversification: Holding a diversified portfolio across different asset classes (stocks, bonds, real estate, etc.) can help cushion the blow of market downturns. When one asset class performs poorly, others might perform better, helping to stabilize overall returns.
• Asset Allocation Adjustments: As you approach retirement, consider gradually shifting your asset allocation to become more conservative. This often means increasing the proportion of bonds and reducing the proportion of stocks in your portfolio. Bonds typically offer lower returns than stocks but are generally less volatile, providing some downside protection.
• Flexible Withdrawal Strategies: Instead of rigidly sticking to a fixed withdrawal rate, consider a more flexible approach. During years with poor market returns, you might consider reducing your withdrawals temporarily if possible, giving your portfolio more time to recover. Conversely, you might increase withdrawals slightly in years with strong returns.
• Delaying Retirement (if feasible): If you experience a significant market downturn close to your planned retirement date, delaying retirement for a few years can give your portfolio more time to recover and grow before you begin withdrawals.
• Annuities: Certain types of annuities can provide guaranteed income streams in retirement, which can help reduce the reliance on portfolio withdrawals and mitigate sequence of returns risk, although they come with their own set of considerations and costs.

In conclusion, sequence of returns risk is a significant factor in retirement planning. Understanding its potential impact and taking proactive steps to mitigate it is crucial for ensuring a secure and comfortable retirement. It emphasizes that the journey of investment returns is just as important as the destination of average returns, particularly as you transition from saving to spending in retirement.