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Sequence of Return Risk
Imagine you're all set to retire. You've saved and invested carefully, but when you start withdrawing from your retirement fund, the market takes a downturn. Even though the market may recover later, those early losses could have a lasting impact on your overall savings. This is Sequence of Return Risk, and it's crucial to understand how it can affect your financial future, especially as you approach retirement.
When planning for your financial future, it's not just the average return that matters—it’s also the order in which those returns occur. While average returns might give you a sense of security, the real-world impact of how those returns are distributed across time can change the outcome of your retirement or financial plan dramatically.
In Real Life: Climbing a Mountain and Sliding Back Down
Think of Sequence of Return Risk like climbing a mountain. Imagine you're climbing steadily, making good progress, but suddenly, you hit a rough patch and slide back down. Now you must work much harder to regain your position, and it takes even more effort to reach the top. In contrast, if you make it past the rough patch early on and continue climbing, reaching the summit becomes easier.
In investing, that "rough patch" is a period of poor market returns. If you hit that rough patch early in retirement and are taking out money to live on, your investments may struggle to recover, just like you would struggle to climb back up the mountain.
Let’s look at two retirees: Mary and John. Both start with $1 million and plan to withdraw $50,000 annually. Mary faces market downturns in the early years, while John has positive returns initially. Even though both experience the same average return over 20 years, Mary’s account runs dry much sooner due to the negative early years, while John’s portfolio continues to grow because of compounding early gains.
This risk becomes especially important when considering the following:
Retirement Timing: If you retire just before a major market downturn, sequence risk could jeopardize your financial security. For instance, imagine retiring just before the 2008 financial crisis—those early withdrawals could force you to sell investments at a loss, permanently reducing your portfolio size.
Withdrawal Strategy: A withdrawal rate that might seem sustainable under normal conditions could become risky if market returns are unfavorable early on.
Michael Kitces, a well-known financial planner, has stated, “The sequence of return risk is not just about how much you earn, but when you earn it. Managing this risk is key to ensuring financial security.
This chart, created by RetireOne, perfectly models the risk of having low returns in early withdrawl years. The same average rate of return (4%) has a return range of over $70,000 when comparing plans that started in an up market to plans that started in a down market.:
- 15 Years at 4% Average Return: $105,944
- 15 Years at 4% Average Return: $35,889
Difference: $70,055
RetireOne. (n.d.). Sequence of returns risk. RetireOne. https://retireone.com/sequence-of-returns-risk/
Key Concept:
The order of returns can affect how long your money lasts, even if the average return over time remains the same.
Mitigating Sequence of Return Risk:
- Cash Reserves: Building cash reserves can help you avoid withdrawing from investments during down markets. This gives your portfolio time to recover and decreases the impact of bad returns.
- Adjust Withdrawal Rates: During periods of negative returns, adjusting your withdrawal rate to be lower can help protect your portfolio from premature depletion. This can be demonstrated in PlanTechHub by adjusting the "Withdrawals" input to see how a more conservative withdrawal strategy impacts plan longevity.
- Diversification and Asset Allocation: Diversifying your assets helps spread risk. A combination of stocks, bonds, and other asset classes can protect you from downturns in any single market.
Visual Demonstration with StartingOutPlan
Using StartingOutPlan's visual tools, you can better understand sequence of return risk by seeing the impact of multiple scenarios.
Randomized Return Sequences: With a click, generate different return sequences to visually compare how each impacts your financial future. As you can see, 2 of these, Return A and B, have multiple years where certain expenses are not funded. Return A, in particular, has 17 years of unfunded expenses based simply on returns being poor at the wrong time. Return C is the only plan that is fully funded every year, and Return D is unique in that all years are funed except for teh very last year. This is one example, but you can clearly see how the same "average" returns can yield dramatically different year to year results when considering the Sequence of Return Risk.
Return A
Return B
Return C
Return D
Interactive Activity: Explore Your Own Risk
Take time to use the "What if returns are randomized" function in StartingOutPlan. Run the sequence randomizer several times and take note of how each scenario affects the future value of your financial plan. Capture screenshots of your results and reflect on how different sequences could influence your real-world financial decisions.
Questions for Reflection:
How does facing negative returns early impact the sustainability of your plan compared to positive early returns?
What changes could you make today to reduce the risk that sequence of returns could derail your financial future?
- How does facing negative returns early impact the sustainability of your plan compared to positive early returns?
- What changes could you make today to reduce the risk that sequence of returns could derail your financial future?
Quote to Remember:
“It's not just about how much your investments grow, but also about the sequence of that growth.”
- Morgan Housel, author of The Psychology of Money
Conclusion
Sequence of Return Risk is one of the most important, yet often overlooked, factors in financial planning—especially in retirement. Understanding it can be the key to securing your financial future. By experimenting with different scenarios using PlanTechHub, you can see how critical this concept is, and what steps you can take to mitigate the risk. While you can’t control market returns, you can control your response, and understanding sequence risk helps you to do just that.
As you progress through your financial literacy journey, remember that your financial health isn't just about hitting a certain average return target—it's also about managing when those returns happen. And with PlanTechHub, you can turn this theoretical concept into an actionable part of your plan.
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