Understanding Sequence of Return Risk: Protecting Your Retirement Portfolio

As retirement approaches, ensuring a financially secure future becomes a top priority for individuals. Many retirees rely on their investment portfolios to sustain their desired lifestyle throughout their golden years. However, there's a hidden risk that retirees must be mindful of: sequence of return risk. This phenomenon highlights the potential impact of the order in which investment returns occur on a retiree's portfolio and can significantly influence their financial well-being.

Sequence of return risk revolves around the timing of investment returns during retirement. Retirees who withdraw funds from their investment portfolios to cover living expenses face the possibility of encountering poor investment returns early in their retirement journey. This unfavorable sequence of returns can have a profound and lasting impact on the longevity of their portfolio.

Let's dive into an example to illustrate the significance of sequence of return risk. Meet John and Sarah, both retiring at the age of 65 with a $1 million investment portfolio. They plan to withdraw 4% of their initial portfolio balance ($40,000) each year to sustain their lifestyle, adjusting for inflation.

In Scenario A, John experiences positive investment returns in the early years of his retirement, followed by negative returns later on. For the first five years, he enjoys average annual returns of 8%. However, the subsequent five years bring an average annual loss of 5%.

In Scenario B, Sarah experiences the opposite sequence of returns. She encounters negative returns in the first five years, averaging -5% per year, and subsequently enjoys positive returns averaging 8% for the next five years.

Comparing their portfolio values at the end of the 10-year period, we find that despite the same average annual returns, John's portfolio grows to approximately $1.23 million in Scenario A. Meanwhile, Sarah's portfolio only reaches around $884,000 in Scenario B. This discrepancy arises from the impact of the sequence of returns.

Here’s a few strategies to help mitigate sequence of return risk:

Get Your Asset Allocation Right.

Determine the right balance between different types of investments based on your risk tolerance and retirement goals. Allocate your assets across a range of investments, such as stocks, bonds, and cash, to create a diversified portfolio. Adjust this allocation as you near retirement to align with your changing needs and market conditions.

Adopt a Flexible Withdrawal Strategy.

Instead of sticking to a fixed withdrawal amount each year, consider a flexible approach. Adjust your withdrawals based on market performance and the health of your portfolio. In years when returns are lower, reduce your withdrawals to preserve your assets and minimize the impact of negative returns.

Establish an Emergency Fund.

Create a separate emergency fund to cover unexpected expenses that may arise during retirement. By having a cushion of readily available cash, you can avoid the need to withdraw from your investment portfolio during periods of market volatility.

As always, these strategies are not “one-size-fits-all.” Working with a financial advisor can help you make better decisions around your retirement and minimize the potential impact of sequence of return risk on your portfolio.