Breaking Down "Sequence of Return Risk"
Sequence of return risk can sound like a scary term, and the threats it poses for new retirees can be serious, so, it is crucial to understand what it is and how it could affect you. Financial professionals have a habit of using a lot jargon, so I'll break it down for you in plain terms.
If you google "sequence of return risk", you'll find over 54 million results. You might be wondering how you've never heard of it before, especially if it's so important. There's a good chance that you haven't heard about it because there is actually no effect from bad sequence of returns if you don't take money out of your investments.
For now, let’s call it “Running Out of Money” risk. You haven't run out of money because you did not save enough. This risk has all to do with the year that you retire and start withdrawing from your portfolio instead of adding more funds.
While you are in your Accumulation phase (which I will go over in detail in an upcoming post), running out of money is not an immediate worry but something that could definitely affect you once you begin the Distribution phase at retirement. So even though this risk may not pose a huge threat to you now, planning for it in advance can save you a whole lot of pain later. A couple of early negative returns at retirement can have horrific consequences on making sure your income lasts for a thirty-year+ retirement horizon. It is a very real risk that many people face right at the start of retirement, and many are totally unprepared for it.
Some professionals advocate being conservatively invested five years before retirement and five years after retirement. They might also advocate the use of target date funds (TDFs), but they do not necessarily solve this problem as each one works differently. If you sell or withdraw from a TDF then you are withdrawing equally from both the lower risk and higher risk assets that are part of that fund.
The first decade is the most important for creating a portfolio that will last an entire retirement life span. If you have accumulated a certain amount of money, say $100, at retirement and your portfolio is 60% stocks and 40% bonds (also known as 60/40) and you take out $5 (or 5%) a year, the sequence of return or return order will determine how long your money will last.
The above chart takes the same twenty-year time period and just reverses the order. By doing this it shows that the outcomes are majorly impacted by the returns in the early years of retirement.
Most retirees are not taught how to build a portfolio to weather bad return order in the early years. A common thought is to look at one's total portfolio as one big pot and to withdraw the earnings each year, otherwise known as living off the interest. On average, retirees spend more in the early years of their retirement-- when the risk of running out of money heightens because of the early bad sequence of returns.
So, what can you do to combat sequence of return risk? There are different solutions depending on whether you are still in the early to mid-accumulation phase or getting ready to enter the distribution phase. Check out those respective posts, coming soon, to see which solutions better suits you.