Sequence Risk: The Dangers of a Disorderly Retirement

Imagine two people washing their hands. Not a particularly difficult visual in today’s environment, is it? The first person applies soap, rinses their hands, and dries them off. Meanwhile, the second person rinses their hands, applies soap, then dries them off. Yuck. Both people have performed the same tasks in the same amount of time, but only one person has properly washed their hands. Why? Order matters. Similarly, the order in which your investment returns occur can have a dramatic impact on how long a portfolio can sustain a stream of income for a retiree.

While it is true that an investor will receive a particular average return in the long run, it is a mistake to assume that you will earn that same long-term average each year. In other words, you may average 6% over the long run, but you won’t make 6% each year. Returns are expected to fluctuate, and periods of negative returns are not abnormal. In the example below, Bill & Jane both average 6% and both suffered a year when they lost 25%.

 

But that’s only part of the story. For those who are taking retirement distributions, the sequence in which you receive your annual returns impacts the longevity of your portfolio. To illustrate, consider Bill & Jane, two hypothetical retirees. Both will retire at the same age with portfolios of $1,000,000, withdraw $40,000 at the start of each year, and earn a long-term average of 6% on their investments in their first four years of retirement. The caveat – the order in which their returns occur will be inverse. Note that the annual withdrawals are inflation-adjusted at 2.25%.

Year

Withdrawal

Bill's Portfolio

Bill's Return

Jane’s Portfolio

Jane's Return

1

$40,000

$1,000,000

30%

$1,000,000

-25%

2

$40,900

$1,248,000

12%

$720,000

5%

3

$41,820

$1,351,952

5%

$713,055

12%

4

$42,761

$1,375,638

-25%

$751,783

30%

   

$999,658

6%

$921,728

6%

 

Bill retired at a more favorable time, experiencing better returns early, while Jane’s portfolio experienced her worst year early in retirement. Due to Jane’s sequence of returns, her portfolio value is worth $77,930 less than Bill’s after four years even though they both averaged a 6% return over that time. It is important to note that since both Bill & Jane are taking distributions from their portfolio, the effects of negative returns are compounded because each dollar withdrawn can no longer benefit from the subsequent price recovery. The result is a decrease in the portfolio’s longevity, which is the number of years your investments can sustain your retirement income needs. In this example above, Bill’s ending portfolio value is assumed to be able to sustain his current withdrawal rate for 25 more years, while Jane’s can only provide her 23 years of income.

Of the many risks that confront today’s retirees, sequence risk is uniquely problematic since it seems to suggest that one’s financial security in retirement is a product of circumstance. Fortunately, there are ways to protect yourself from sequence risk. At Pathfinder Wealth Consulting, our team of CERTIFIED FINANCIAL PLANNER™ Professionals have developed effective strategies for mitigating the long-term impact of sequence risk and protecting the longevity of our retiree’s nest eggs. These strategies have allowed our retirees to maintain their retirement lifestyles through volatile times like the dot-com bubble of ’01-’02, the Great Recession of ’07-’08, and most recently, the “Coronavirus Crash” of 2020. To learn more about how you can manage your exposure to sequence risk and plan for a more secure retirement, give us a call at 910-793-0616 today.

*This is a hypothetical example and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results. No investment strategy can guarantee a profit or protect against loss.