Sequence of returns – A significant risk that should not be ignored

On the Money

Recent market volatility provides a vivid reminder that markets rarely go up or down steadily. And when markets trend down at a time when an investor is approaching or recently entered retirement, this can be cause for real concern. In fact, sequence of returns, the order in which investors experience returns, is one of the biggest potential risks to a retirement portfolio.

In football, inside the 20-yard line is referred to as the “red  zone.” In retirement planning, the five years just prior to and just after retirement are considered to be the “retirement red zone.” An investor just entering retirement who begins withdrawing money and experiences a period of negative returns could find that the timing of these negative returns leads to a significant reduction in his livelihood.

Two investors with the same long-term average return may end up with very different results depending on the order of those returns. Consider these two 20-year scenarios – one starting in 1989 and ending in 2008 and the second a simple reversal of the sequence. In each case, the average annual return is the same, 8.43 percent. But the outcome for the two investors who commence retirement in each of those two years is dramatically different.

Let’s assume both investors start with:

  • $1 million
  • 100 percent invested in an S&P 500 Index Fund.
  • Withdraws 5 percent or $50,000 in the first year.
  • Increase annual withdrawal rate for inflation assuming 3 percent.

In the first scenario, 1989 to 2008, an investor experiences several good years, including a 31 percent gain in the first year. Over 20 years, the portfolio grows to $3.1 million.

In striking contrast, the investor in the second scenario with the reverse sequence of returns faces an immediate downdraft of 37 percent in the first year, followed by significant declines in years seven, eight and nine. That portfolio shrinks to $235,000 after 20 years.

Again, the average annual return in BOTH scenarios is 8.43 percent. We should point out that this is an extreme example with 100 percent of the portfolios invested in stocks.

For most investors, adequate planning and a well-diversified portfolio can reduce the potential risk due to sequence of returns. Maintaining some flexibility around the timing of withdrawals – and even the timing of retirement – can offset the potential impact of unexpected negative returns.

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