Sequence of Returns Risk

Approaching retirement is a significant milestone in one’s life journey, marking the transition from years of hard work to a period of newfound freedom and relaxation. However, in the midst of the excitement of retirement planning, there exists a crucial yet often overlooked factor that can profoundly influence retirees’ financial security: the sequence of returns. In this article, we’ll delve into the effects of sequence of returns when approaching retirement, exploring its implications, challenges, and strategies to mitigate its impact.

So what exactly is the Sequence of Returns? Basically, it’s the impact that either a Bear market or a Bull market will have on a portfolio (sequence risk). For recent retirees (or those thinking about retiring), the impact of sequence risk poses a significant threat to their financial security. Market volatility can happen on a daily basis. Sharp fluctuations in asset prices can significantly impact portfolio values, especially for retirees who rely on their investments for income. During the accumulation phase, individuals have the advantage of time to weather market downturns and recover from losses. However, in retirement, when withdrawals from the portfolio are necessary to cover living expenses, the sequence of returns becomes critically important.

Let’s consider a recent retiree (or soon to be) who plans to take withdrawals from his or her investment and/or retirement accounts in a Bull market to generate income in addition to Social Security and perhaps, a pension. They are no doubt thrilled not only by the ability to take income withdrawals from their account(s) that they’ve worked so hard to build over their career, but also by the fact that their account value may also increase. For this retiree, retirement is exactly what they dreamed of.

Let’s also consider a retiree who begins withdrawing funds from their portfolio during a Bear market (prolonged market downturn). Not only does the portfolio suffer from the market decline, but the withdrawals exacerbate (and often accelerate) the losses, leaving less capital to benefit from future market recoveries. This scenario can potentially deplete the portfolio at a faster rate, jeopardizing the retiree’s financial sustainability. A prolonged bear market early in retirement can have devastating effects on a retiree’s financial security, making it challenging to recover even when markets eventually do rebound.

To illustrate the effects of Sequence Risk by example, please click here to reference a handout I’ve included. 

Per the handout, Page Two shows the effects of Accumulation over a 25 year period ($100,000 starting value). Portfolio A shows the first three years of declines, but ends with three years of gains. Portfolio B’s returns are simply Portfolio A’s returns flipped (first three years have gains, with the last three declines). The end result however, is the same; both portfolios end with the same accumulation value at the end of 25 years ($691,527.49).

Page Three shows the effects of a 5% annual Systematic Withdrawal taken from the end accumulation value of $691,527.49 using the same 25 year returns as shown in the accumulation mode (with Portfolio B’s returns are Portfolio A’s “flipped”). Note how quickly Portfolio A runs out of money in 16 years (starting out with three years of declines), while Portfolio B not only sustains its withdrawals, but increases in value over time, all due to starting with three years of gains. 

There’s also the Psychological Effect regarding withdraws from a Bear market. The fear of running out of money or not being able to maintain the desired standard of living can lead to increased stress and anxiety, undermining the enjoyment of retirement years. This type of stress can also have a direct, negative impact on physical health, as well. 

Strategies to Mitigate Sequence Risk: While sequence risk cannot be eliminated entirely, there are several strategies retirees can employ to mitigate its impact and enhance their financial security. 

They are: 

• Diversification: Allocating investments across different asset classes can help spread risk and reduce the portfolio’s vulnerability to the poor performance of any single asset or market segment.

• Asset Allocation: Maintaining a balanced asset allocation aligned with your risk tolerance and investment objectives can cushion the impact of market volatility on your portfolio.

• Dynamic Withdrawal Strategies: Consider flexible withdrawal approaches, such as the “bucket” strategy, where retirees maintain a mix of short-term, medium-term, and long-term assets to fund living expenses while allowing the rest of the portfolio to grow or recover.

• Insurance Products: Certain insurance products, such as annuities or guaranteed income solutions, can provide a steady stream of income during retirement, shielding retirees from the adverse effects of market downturns.

• Regular Monitoring and Adjustment: Stay vigilant about your investment portfolio’s performance and make necessary adjustments to your strategy as circumstances change, such as revisiting your asset allocation or spending rate.

In conclusion: As retirees approach the milestone of retirement, understanding the impact of sequence of returns is paramount to safeguarding their financial security. By recognizing the challenges posed by sequence risk and implementing prudent strategies to mitigate its effects, retirees can increase the likelihood of achieving their retirement goals and enjoy a fulfilling and worry-free retirement journey.

If you’d like to discuss the importance of Sequence of Risk and how it can impact either your retirement income or someone you know, please reach out to me at 941-704-3134 or email me at d.babecki@db3insurancservices.com. By doing so, we can remove any doubt you might have regarding generating income during retirement.

Thanks again for reading, and…

Let’s Make Sure You and Your Family’s Needs Are Covered In 2024!

Sincerely,

David J Babecki

The above article reflects the opinions and thoughts of David J. Babecki. The information contained in this material is believed to be reliable, but not guaranteed. It is for informational purposes only and is not a solicitation to buy or sell any products which may be mentioned. It is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual’s situation.

Please note: All guarantees and/or promises are based on the claims-paying ability of the respective insurance company.