I recently received a subscriber request to explain sequence of returns financial risk and why it is important in retirement planning. So here goes.
Defining Sequence‐of‐Returns Risk (SRR)
SRR is a financial risk that is of particular importance to individuals that have accumulated assets and are entering or recently began retirement. It is the risk that an investor will experience negative portfolio returns during early retirement or in the years leading up to retirement. Sequence-of-returns risk is a significant threat because retirees or pre-retirees, because of their age, have little time to make up for losses on their accumulated savings that are compounded by the simultaneous need to drawdown cash in the form of distributions to pay living costs.
At retirement, full-time work, a regular paycheck and additional savings cease. Individuals’ key financial objective switches from maximizing accumulation to creating a stream of withdrawals they can live on for their lifetimes. They have also reached an age when they cannot wait 8 to 10 years for asset values to recover should they decline as they need the current income from their assets to live on.
Let’s look at an example couple that has saved $900,000 and they plan on taking 3% (a safe rate of withdrawal to help reduce their risk of running out of money) out each year or $27,000 in retirement income, which along with their expected Social Security benefit, will pay their living expenses. Now let’s assume that a market event takes place a few weeks after retirement and the financial markets suffer a large decline in value and their $900,000 balance drops 30% to $630,000.
Now their safe withdrawal at 3% is cut to $18,900 and they don’t have enough income to pay their living expenses. Taking this withdrawal also locks in the 30% loss on the amount distributed as they can’t wait for the account value to recover. This loss of the value of their assets is based on the “sequence” of market returns. On the other hand the value could increase 10% to $990,000 and their withdrawal at 3% would increase to $29,700. The reality is that they can’t control the rate of return on their assets or when it will increase or decrease.
If the value of their portfolio does not recover from the 30% decline, the income they planned to receive may be insufficient to pay their living expenses and they may need to adopt a lesser lifestyle. Another option they have, is that they could continue to withdrawal $27,000 per year and risk exhausting their assets.
So when analyzed, SRR risk goes beyond simple market volatility risk because it is a function of both the timing of market returns and the timing of needed portfolio withdrawals. When cash flows occur over an investment horizon, the sequence of returns―whether monthly, quarterly, or annually—may have a considerable impact on outcomes. While contributions before retirement and withdrawals after retirement both can produce SRR effects, withdrawals after retirement are typically of greater concern because they may “lock in” losses after a period of poor returns, ultimately leading to premature exhaustion of portfolio assets.
Summary
SRR risk is one reason why households should work with a financial professional in setting up their retirement income planning. The professional can help select the right composition and allocation of the accumulated assets to protect against SRR and keep retirement income at necessary levels to comfortably pay living expenses.