Like many people, you may be saving diligently for retirement by contributing regularly to a retirement savings account like a 401(k) or IRA. This is a great way to help ensure that you have a financially comfortable retirement.
However, there’s a hidden risk to a financially secure retirement that many people aren’t aware of. It’s called the sequence of returns risk — understanding this risk now can help you avoid it later when you begin making retirement plan distributions.
Dynamic Annual Returns
Sequence of returns describes the variation in an investment portfolio’s annual rate of return over a number of years. The average annual return of a retirement or investment portfolio is dynamic. In other words, it changes every year, sometimes drastically. Some years your portfolio could be way up and some years it could be way down.
During the accumulation phase of retirement planning, the sequence of returns means little in terms of the portfolio’s value when you ultimately reach retirement. Deviations from the mean will influence your annual rate of return, of course, but they won’t impact your portfolio’s final value when you’re ready to retire.
Research performed by investment management firm BlackRock makes this clear. The researchers compared three model investing scenarios, each starting with a lump sum of $1 million and averaging a 7% annual return over 25 years. In two of the portfolios, annual returns varied widely from -7% to +22%. In the third portfolio, the return was an even 7% every year. However, the ending value of all three portfolios after 25 years was exactly the same: $5,434,372.
Shifting to Asset Distribution
Things change when we shift from the asset accumulation to the asset distribution phase of retirement planning. This is where sequence of returns risk comes into play. In short, the performance of investment markets when you withdraw money from your retirement account will greatly affect how long your retirement savings last. And this, in turn, will have a big impact on whether you outlive your retirement savings.
The risk is that your retirement date will coincide with a down market. A bad year or two early in the asset distribution phase could have a permanently negative effect on your portfolio’s long-term balance.
If the lowest returns occur when you first start taking withdrawals and the highest returns occur later, this will decrease the value of your portfolio over the long term. Conversely, if the highest returns occur when you first start taking withdrawals and the lowest returns occur later, this will increase the value of your portfolio over the long term.
An example illustrates the potential negative impact of sequence of returns risk. In early 2008, Andrew and Trish had a retirement portfolio worth $1 million that was allocated with 60% stocks and 40% bonds. They planned to retire at the end of the year. However, the stock market (as measured by the S&P 500 Index) fell 37% that year while the bond market (as measured by S&P U.S. Aggregate Bond Index) rose 5.7%. As a result, their $1 million portfolio had fallen by about 20% to $800,800 by the end of the year. They decided to postpone their retirement to give their portfolio time to recover.
It’s hard to make up for market declines during the early years of portfolio withdrawals. If your retirement portfolio loses 5% of its value in one year while you’re also withdrawing 5% of the portfolio balance, it will take a 16.8% return the following year just to restore the original portfolio balance. Increase this to a 10% loss of portfolio value in one year with the same 5% withdrawal rate and the return required the following year to restore the original portfolio balance rises all the way to 23.7%.
Avoid Early Negative Returns
The moral of the story is that it’s critical to avoid negative returns during the early years of retirement plan withdrawals. If distributions begin during a historically bad year in the markets, like 2008 was, a portfolio might never be able to recover from the damage.
Give us a call if you have questions about sequence of returns risk or any other aspects of retirement planning.