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If I Could Only Teach One Financial Lesson: The Importance of Understanding Sequence of Returns Risk

If I Could Only Teach One Financial Lesson: The Importance of Understanding Sequence of Returns Risk

| September 13, 2022

Among the many wonderful things I have learned in my 15 years as a financial planner, as well as insights shared by my mother (who was also a financial planner), there is one lesson that is particularly important to me and my work with people close to or in retirement—and it’s not as widely discussed as it should be. 

Many of us have heard about the need to plan for retirement, the power of compound interest, and the wise counsel to save 10% or more of your income for retirement, but the one financial lesson I would share is this:

In retirement, the order of returns you get, especially early in retirement, greatly affects how long your nest egg will last. This is known as the sequence of returns risk in the financial planning world.

In essence, if you retire and subsequently have poor market returns, combined with ongoing distributions, you could significantly lessen the longevity of your portfolio and put your retirement at risk. But don’t worry: there are ways to mitigate this risk with proper planning.

What Is Sequence of Returns Risk?

As you plan for your retirement in your working years, you might use an assumption for the type of return you receive for your investments. This is a common and intelligent strategy, as it helps you plan for the future, even if we know that our assumption won’t be 100% accurate.   

As you work and invest, you might assume a 9% return on your investments over multiple decades. Some years will come close to that number or even exceed it by quite a bit, while other years will be more modest or even negative. It isn’t of great significance what happens in each particular year as long as the average comes close to 9%.

When you enter retirement, however, the annual returns you get each year, especially early in your retirement, are critically important. (1)To fully understand why that is, let’s look at some examples.

Examples of Sequence of Returns Risk

Let’s assume that a retiree can get the following returns: (2)

As you may have noticed, the returns are the same except they are in opposite order. Scenario A starts out with positive returns that turn negative, while Scenario B starts with negative returns that turn positive. In the end, they each average an annual return of 2.78%.

There’s no difference between them yet. However, let’s assume that a retiree has $100,000 in their portfolio, and plans to take annual distributions of $10,000. What would happen in Scenario A and in Scenario B?

In Scenario A, the positive early returns would lessen the effect of the annual distributions, and leave the retiree with more than $70,000 at the end of 5 years.

In Scenario B, the negative early returns, combined with the annual distributions, would leave the retiree with only $47,000 at the end of 5 years. 

That $23,000 difference in portfolios is not because of the average return, but rather the sequence of when those returns occurred.

Financial planner Michael Kitces summarizes it well when he says, “Simply put…the sustainability of portfolio withdrawals is driven far more by the sequence of returns that occur, than the actual long-term return itself.” (3)

Strategies to Mitigate Sequence of Returns Risk

We know that we cannot control or predict what the stock market will do, or what our investment returns will be. There are, however, ways to mitigate the sequence of returns risk in retirement. (4)

First, keep a healthy amount of cash in reserves in case you experience a downturn early in your retirement. If you keep one to two years’ worth of withdrawals in cash in a separate account, that could be used for living expenses instead of depleting your portfolio at an inopportune time.

Second, be flexible on how much income you need to take each year. There is no rule that says you need to take the same amount of income from your investments each year. If you can take less income during years of poor market performance, that could help the longevity of your portfolio.

Third, consider an annuity to create an income for the length of your life. While there is a lot to weigh before buying an annuity, if you are worried that your portfolio won’t last as long as you need it to, one option is an immediate or deferred annuity. These instruments provide an income for as long as someone lives.

Let’s Get Started

If you’d like to create a retirement income plan that aligns with your goals and mitigates your risk of running out of money, I’d love to help. You can schedule an introductory meeting online or reach out to me at (770) 627-4157 or to get started. 

About Scott

Scott Bechely is financial advisor at Horizon Planning Group, a full-service fiduciary financial planning firm committed to always doing what’s right for their clients. Scott uses his more than 15 years of experience to help his clients create a retirement income plan that aligns with their goals and helps them live the retirement lifestyle they dream of. He believes that everyone should have a chance to obtain financial independence, and he strives to help his clients design a plan that helps them sleep better at night knowing they’re on track for their ideal future.

Scott is a CERTIFIED FINANCIAL PLANNER™ professional who graduated magna cum laude from the University of Georgia with a bachelor’s degree in business administration, focusing on finance. Outside of work, he can often be found spending time with his wife, Sara, their daughter, Anna, and their dogs, Ginger and Bailey. He loves sports and enjoys playing in his baseball league and golfing. He gives back to his community by supporting his favorite dog rescue organizations: Adopt A Golden and Golden Retriever Rescue. To learn more about Scott, connect with him on LinkedIn.