Learn How Sequence Risk Impacts Your Retirement Money
Sequence risk, or sequence of returns risk, has to do with 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 thought you were going to earn. 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. Below 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. Now suppose those returns shown above occurred in the opposite order (as shown below in this article).... you ended up with the same amount of money: $238,673. 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).
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 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.
Returns Occur in the Opposite Order
Now suppose you retired in 1996, you invest the same $100,000 and draw out the same 6,000 a year - but the returns listed above happened in the exact opposite order, as shown below.
- 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%
(Additional returns data available in historical market returns.)
Once you are withdrawing income the change in the sequence in which the returns occurred did affect you. Now at the end of the ten years, you had 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 sequence of returns risk.
When retired, because you need to be selling investments periodically to support your cash flow needs, if the negative returns occur first, you end up selling some holdings, and thus reducing the shares you own that are available to participate in the later-occurring positive returns.
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 which case a negative sequence of returns early on works to your benefit as you buy more shares). But when you are taking income, you are 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 plugging a simple rate of return into an online retirement planning tool is not an effective way to plan for retirement. The online tool 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 twenty year period you might earn 10% plus returns, and in a different twenty year time period you would 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 reflective of some of the worst decades in the past. This way if you get a bad sequence (bad economy) you have already planned for it.
Having a disciplined investment process in place can also help manage sequence risk. Withdrawal Rate Rules for Creating Retirement Income provides six guidelines you can use to help adjust your withdrawals as you go. Another option is to use investments that provide guaranteed income. 7 Ways to Build a Floor of Guaranteed Retirement Income will give you some ideas on how to approach this.
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 5 - 10 years worth of cash flow needed). In this way, the rest of your portfolio can be in equities and 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.