Sequence of Returns Risk – Why It Matters for Your Retirement
October 11, 2022
When you’re working to accumulate wealth over an extended time, you’ll reap the benefits of positive returns in some years, and in others, your returns might be in negative territory.
The order, or sequence, of these returns doesn’t matter much while you’re still working and growing your wealth. However, during retirement, the order of when you have positive and negative annual returns matters much more.
For example, if you suffer significant losses early in retirement, it can take quite a while to recover, and it could even derail your retirement plans.
Because we don’t have a crystal ball to see into the future, it is important to manage what we call “sequence of returns risk.” Here’s why the sequence of returns matters to soon-to-be and recent retirees and how to protect your portfolio from this risk.
What Is the Sequence of Returns?
The phrase “sequence of returns” refers to the order of investment returns for a portfolio over a specific time.
For example, the annual returns over a hypothetical three-year period may come in the following sequences:
|Year||Return Sequence 1||Return Sequence 2|
Notice in this example, the annual returns are the same, but in the reverse order. Therefore, the average return of these two sequences is the same, as well. However, average returns don’t tell the whole story.
While you’re working and saving for retirement, either sequence will produce the same outcome. But once you transition into retirement, different sequences can lead to significantly varied results.
Why does this happen? Because when you retire, you’ll begin taking withdrawals. When you withdraw from your savings during a market decline, you take an even bigger chunk out of your already-reduced balance. That money then no longer has the ability to recover when the markets turn around.
High inflation makes this scenario an even bigger problem because you’ll need more money to cover your everyday expenses. Therefore, you’ll likely need to withdraw a larger percentage of your balance.
The example below shows how the impact of withdraws and returns can have different outcomes for your investments.
Strategies to Manage Sequence of Returns Risk
Because the sequence of your returns has the potential to be so disruptive early in retirement, it’s essential to manage this risk effectively before and once you begin withdrawing.
Here are several strategies that can help manage this portfolio risk:
- Build up your savings as you approach retirement. A larger nest egg can help you weather difficult markets. And the more you can leave invested, the better your money will benefit from a market rebound.
- Manage your spending and be willing to adjust as needed. Reducing your withdrawals after a market decline can insulate you from sequence risk. Paying off as much debt as possible before you retire can give you more flexibility in your monthly budget.
- Increase your income to reduce the amount you need to withdraw from your investments. Ways to boost your income might include taking a part-time job, starting early Social Security withdrawals, or purchasing an annuity that provides lifetime income.
- Diversify your investments and ensure they are aligned with your goals. Consider whether you need to rebalance your portfolio based on your time horizon and risk tolerance as you move closer to retirement.
How to Plan with Sequence of Returns
The best way to evaluate sequence of returns risk is to consider different scenarios when planning for retirement. Many retirement planning tools use a static average rate of return for the projected investment growth, but you’ll want to consider a range of different return sequences.
That’s why, at Trinity Wealth Management, we use Monte Carlo simulation, a statistical tool that estimates various outcomes. This method helps illustrate the many possible results of your financial plan across a range of market conditions.
We stress-test your plan using 1,000 different return sequences based on your investment allocation. The plan’s probability of success is then calculated using the number of successful sequences. In other words, the percentage of time your investments lasted until the plan’s end (usually age 90 to 95). The analysis helps us understand how sustainable your retirement plan is and your exposure to sequence risk.
Because each simulation is based on your specific plan, we can test other planning scenarios. For instance, we can see the effects of:
- Retiring early versus working longer
- Spending more versus spending less
- How a future purchase, like a second home, or gifting to family or charity will impact your finances
In addition, we can show you if recent market declines have negatively affected the long-term outcome of your financial plan and how to get back on track.
Ultimately, this helps you make more informed financial decisions based on the visible impact of different scenarios.
Let Trinity Wealth Management Plan Your Retirement
If you’re wondering how withdrawals and the sequence of returns might impact your retirement, then Trinity Wealth Management can help.
Contact us today to learn more about how we can help you plan for and navigate a comfortable retirement
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