Understanding Sequence of Returns Risk: Timing Can Make or Break Your Retirement

When planning for retirement, many people focus on average returns. They might think, "If I get a 6% return each year, I'll be fine." But what if those returns don't come evenly? What if the market takes a downturn just as you start withdrawing from your portfolio? This is where the concept of "Sequence of Returns" risk becomes critical—and potentially devastating.

What is Sequence of Returns Risk?

Sequence of Returns risk refers to the order in which your investment returns occur. When you're saving for retirement, market fluctuations don't have as much impact—there's time to recover from a bad year. However, once you start withdrawing money in retirement, the sequence in which you experience gains and losses matters a lot more.

If you encounter significant losses early in retirement, while you're withdrawing funds, your portfolio could deplete faster than anticipated. This increases the risk of running out of money, even if the market recovers later on.

A Story of Two Retirees

Let me introduce you to two retirees, John and Sarah, who both retired at age 65 with $1 million in their portfolios. They each plan to withdraw $50,000 annually to cover their living expenses.

John's Story: John retires in a booming market. For the first three years, he enjoys strong returns of 10%, 12%, and 8%. Even after withdrawals, his portfolio grows to $1.1 million. After the initial gains, the market takes a hit, with negative returns of -15% and -10% in the following two years. However, because John's portfolio had grown, the impact of these losses is less severe. By year 10, John's portfolio, despite the ups and downs, has stabilized around $950,000, and he's feeling confident about his financial future.

Sarah's Story: Sarah, on the other hand, retires just as the market takes a downturn. In her first three years, she experiences losses of -10%, -15%, and -8%. After just three years of withdrawals, her portfolio has shrunk to $750,000. Even though the market rebounds in the subsequent years with returns of 10%, 12%, and 8%, Sarah's reduced portfolio size means the gains have a smaller impact. By year 10, Sarah's portfolio is down to $500,000, and she's growing concerned that her money might not last through retirement.

Why Timing Matters

In both cases, John and Sarah experienced the same average annual return over the course of ten years. Yet, because Sarah's losses occurred early in her retirement while she was withdrawing funds, she ended up in a far worse situation. This is the essence of Sequence of Returns risk—timing can drastically affect your financial security in retirement.

How to Protect Yourself

So, how can you guard against Sequence of Returns risk? Here are a few strategies:

Diversify Your Income Sources: Instead of relying solely on your investment portfolio, consider other income streams like Social Security, pensions, or annuities. These can provide stability even if your investments suffer.
Maintain a Cash Reserve: Keeping a few years' worth of living expenses in cash can help you avoid withdrawing from your portfolio during a market downturn, giving your investments time to recover.
Consider a Staggered Withdrawal Strategy: Instead of withdrawing a fixed amount each year, adjust your withdrawals based on market conditions. This might mean taking less during down years and more during good years.
Work with a Financial Advisor: A professional can help you create a plan that considers Sequence of Returns risk and other factors to ensure your retirement is as secure as possible.

Conclusion

Sequence of Returns risk isn't just a theoretical concept—it's a real risk that can have a significant impact on your retirement. By understanding it and planning accordingly, you can reduce the risk of running out of money and enjoy a more secure and comfortable retirement.