April 1, 2016
Sequence of Return Risk
If you’re retired or thinking about retiring, first of all, congratulations! Second of all, if you’re taking money from your investments I encourage you to adhere to the following information. Assuming you’re like most retirees who are forced to pull money from your investments to maintain the lifestyle you’ve become accustomed to, there’s an additional risk out there that you need to be aware of. This is the risk of sequence-of-return
Sequence Risk is defined as the risk of small or negative returns during periods of consistent withdrawal. Those who are the most prone to this risk are retirees who are living off of the income on their investments. When we’re talking about sequence-of-return risk, it’s the timing of one’s returns that can have a significant impact one’s financial wealth. Hypothetically, an investor planning to have $1 million at retirement could save $300 per month for 40 years. Assuming an 8% rate of return this strategy would work. The issues is that this example assumes a steady 8% every year. As investors we know that this is not realistic. A large deviation from the hypothetical 8% return can have a dramatic effect on the sustainability of retirement distributions from the portfolio. This is sequence-of-return risk.
Traditionally, the view is that sequence-of-return risk matters to retirees as they draw money from their portfolio, especially during the early years of retirement. However, it’s very important to note that sequence-of-return risk is equally important for people approaching retirement years. The difference is timing. For retirees, getting poor returns at the beginning of their retirement can be extremely detrimental. For people not yet retired, their biggest risk is getting bad returns as they near retirement. For an accumulator (someone approaching retirement) we will call this “retirement date risk.” Understandably, the more an investor is relying on portfolio returns, there is a greater danger of retirement date risk.
Consequently, someone approaching retirement or beginning retirement may want to reduce volatility in their portfolio in order to avoid sequence-of-return risk. On the other hand, being more conservative may force someone approaching retirement to work longer, save more, or spend less in retirement, which is not always an option. Monte Carlo analysis can help in this instance.
A retiree that begins their retirement in the bottom of a bear market will see reduction in return if they continue to take withdrawals near or at the bottom of the market. Sequencing risk is the risk that the timing of your returns is unfavorable and results in less for money for retirement. When there are no cash flows in a portfolio this risk doesn’t exist, but this is not the case for most. The combination of most retirees having more money at risk now than they ever have in the past, and many taking income from their portfolios puts sequencing risk at its greatest point. If a high proportion of negative returns occur in the beginning of your retirement, this can drastically reduce the amount of income you’ll be able to withdraw during your life time. One way to protect against this risk is having a plan for it.
One of the best plans there is to have an investment team like Gainplan on your side that manages the risk in your portfolio, but another is an adjustment to your withdrawal strategy. It’s important to have a withdrawal plan in retirement, as the timing of withdrawals have a long term effect on overall portfolio health. When in a bear market and portfolio values are down, take a pay-cut, but when the market’s on a tear I think it’s time for a raise!
Long story short, investments involve risk and whenever there are cash flows in a portfolio sequence of return risk is also present. There are several ways to reduce one’s sequence of returns risk which can have a drastic impact on one’s financial wealth. Having a plan into the future is essential to minimizing the impact of the sequence of returns risk on your portfolio and your lifestyle.
This commentary on this website reflects the personal opinions, viewpoints and analyses of the Gainplan LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Gainplan LLC or performance returns of any Gainplan LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Gainplan LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.