Sequence Risk's Impact on Your Retirement Money
Sequence risk, or sequence of returns risk, analyzes the order in which your investment returns occur. It affects you when you are periodically adding or withdrawing money from your investments. In retirement, it can mean that you earn a much lower internal rate of return than what you expected. The best way to understand sequence risk is with an example.
Accumulation: No Additions, No Sequence of Returns Risk
Suppose you invested $100,000 in 1996 in the S&P 500 Index. These are the index returns:
- 1996: 23.10%
- 1997: 33.40%
- 1998: 28.60%
- 1999: 21.0%
- 2000: -9.10%
- 2001: -11.90%
- 2002: -22.10%
- 2003: 28.70%
- 2004: 10.90%
- 2005: 4.90%
Your $100,000 grew to $238,673. Not bad. Your $100,000 earned just over a 9% annualized rate of return.
If Returns Occur in the Opposite Order
Now if those returns played out in the opposite order, you still would have ended up with the same amount of money: $238,673.
- 1996: 4.90%
- 1997: 10.90%
- 1998: 28.70%
- 1999: -22.1%
- 2000: -11.90%
- 2001: -9.10%
- 2002: 21.0%
- 2003: 28.60%
- 2004: 33.4%
- 2005: 23.10%
The order in which the returns occur has no effect on your outcome if you aren't either investing regularly (buying investments) or withdrawing regularly (selling investments).
Once you start withdrawing income, you're affected by the change in the sequence in which the returns occurred. Now at the end of the 10 years, you have received $60,000 of income and have $125,691 left. Add the two together and you get $185,691. This equates to about a 7.80% rate of return. Not bad, but not as good as the $222,548 you would have received if the returns had happened the other way around.
During your retirement years, if a high proportion of negative returns occur in the beginning years of your retirement, it will have a lasting negative effect and reduce the amount of income you can withdraw over your lifetime. This is called the sequence of returns risk.
When you're retired, you need to sell investments periodically to support your cash flow needs. If the negative returns occur first, you end up selling some holdings, and so you reduce the shares you own that are available to participate in the later-occurring positive returns.
Withdrawing Income and Getting the Same Returns
Now suppose instead of the above scenario, you retired in 1996. You invested $100,000 in the S&P 500 Index, and you withdrew $6,000 at the end of each year. Over the ten years, you received $60,000 of income and you would have $162,548 of the principal left. Add those two up and you get $222,548. Again, you earned over a 9% rate of return.
Withdrawal Rate Rules for Creating Retirement Income offers six guidelines you can use to help adjust your withdrawals as you go.
Sequence Risk Is Somewhat Like Dollar Cost Averaging in Reverse
A sequence of returns risk is somewhat the opposite of dollar cost averaging. With dollar cost averaging, you invest regularly and buy more shares when investments are down. In this case, a negative sequence of returns early on works to your benefit as you buy more shares. When you're taking income, you're selling regularly, not buying. You need to have a plan in place to make sure you aren’t forced to sell too many shares when investments are down.
Protecting Yourself From Sequence Risk
Because of sequence risk, it's not an effective way to plan for retirement by plugging a simple rate of return into an online retirement planning tool, which assumes you earn that same return each year. A portfolio doesn't work that way. You can invest the exact same way, and during one 20-year period, you might earn 10% plus returns, and in a different 20-year time period, you'd earn 4% returns.
Average returns don't work either. Half the time, returns will be below average. Do you want a retirement plan that only works half the time? A better option than using averages is to use a lower return in your planning; something that reflects some of the worst decades in the past. This way, if you get a bad sequence (a bad economy), you've already planned for it.
You could also create a laddered bond portfolio, so that each year a bond matures to meet your cash flow needs, you would cover the first five-to-10 years worth of cash flow needed. In this way, the rest of your portfolio can be in equities. Since this equity portion is in essence still in the accumulation phase, you can choose to harvest gains from it to buy more bonds in years during or after strong stock market returns.
The best thing you can do is understand that all choices involve a trade-off between risk and return. Develop a retirement income plan, follow a time-tested disciplined approach, and plan on some flexibility.