Understanding Sequence of Returns Risk: Why Timing Matters More Than Average Returns

Investing for the future is a marathon, not a sprint. We often focus on average returns, picturing a steady upward climb to our financial goals. However, a hidden danger lurks beneath the surface: Sequence of Returns Risk (SORR). This refers to the risk that the timing of your investment returns, particularly negative returns early in your withdrawal phase (retirement), can significantly impact the longevity of your portfolio, even if your average returns are healthy.

In essence, SORR highlights that it’s not just how much you earn, but when you earn it that truly matters.

Why is Sequence of Returns Risk So Important?

Imagine two investors, Alice and Bob, both starting retirement with a $1 million portfolio and aiming to withdraw $50,000 per year, adjusted for inflation. They both achieve an average annual return of 7% over 30 years. Sounds like a success story, right?

Not necessarily. Here’s the catch:

• Alice experiences negative returns early on in her retirement. Think about the market downturns of 2008 or the recent economic uncertainties. If Alice encounters these early in her withdrawal phase, she’s forced to sell off a larger portion of her portfolio to cover her living expenses while the market is down. This locks in those losses and makes it harder for her portfolio to recover.

• Bob experiences the negative returns later in his retirement. By this point, his portfolio has had time to grow substantially. He can withstand those late-stage market fluctuations more easily because the impact on his long-term sustainability is less severe.

Even though both Alice and Bob achieved the same average return, Alice might run out of money significantly sooner than Bob due to the unfavorable sequence of returns she experienced early in her retirement.

The Mechanics of Sequence of Returns Risk:

Here’s a simplified breakdown of how SORR works:

1. Early Withdrawals + Negative Returns = Accelerated Portfolio Depletion: When you withdraw money from your portfolio while it’s experiencing negative returns, you’re selling off assets at a lower price. This reduces the overall size of your portfolio, making it harder to rebound when the market recovers.

2. Reduced Compounding Power: A smaller portfolio earns less in subsequent years, hindering the compounding effect that is crucial for long-term growth.

3. Higher Withdrawal Rate Required: As your portfolio shrinks, you’re forced to withdraw a larger percentage of the remaining assets to meet your income needs. This further accelerates the depletion process.

Who is Most Vulnerable to Sequence of Returns Risk?

• Retirees and those nearing retirement: This group is particularly susceptible because they are actively withdrawing funds from their portfolio. A bad sequence of returns early in retirement can be devastating.
• Those with high withdrawal rates: The higher the percentage of your portfolio you’re withdrawing, the more vulnerable you are to the impact of negative returns.
• Those with shorter time horizons: If you’re closer to your financial goals, there’s less time to recover from market downturns.

Strategies to Mitigate Sequence of Returns Risk:

Fortunately, you can take steps to protect yourself from SORR:

• Diversification: Don’t put all your eggs in one basket. Diversify your portfolio across different asset classes (stocks, bonds, real estate, etc.) to reduce overall volatility.
• Asset Allocation Adjustment: Consider gradually shifting your portfolio towards a more conservative allocation as you approach retirement. This typically means increasing your allocation to bonds, which are generally less volatile than stocks.
• Cash Cushion: Maintain a cash reserve to cover several years of living expenses. This allows you to avoid selling investments during market downturns.
• Flexible Spending: Be prepared to adjust your spending habits during market downturns. If possible, reduce your withdrawals temporarily to allow your portfolio to recover.
• Consider Annuities: A fixed annuity can provide a guaranteed income stream, reducing your reliance on portfolio withdrawals.
• Delay Retirement (if possible): Working even a few extra years can significantly boost your portfolio and reduce the withdrawal period.
• Professional Financial Advice: Consult with a qualified financial advisor to develop a personalized retirement plan that addresses your specific risk tolerance and financial goals. They can help you model different scenarios and identify strategies to mitigate SORR.

Conclusion:

Sequence of Returns Risk is a real and significant threat to long-term financial security, especially for those in or near retirement. While average returns are important, understanding the potential impact of the timing of those returns is crucial for developing a resilient retirement plan. By implementing appropriate strategies like diversification, asset allocation adjustments, and maintaining a cash cushion, you can mitigate SORR and increase the likelihood of a financially secure retirement. Don’t let an unfavorable sequence of returns derail your financial dreams – be proactive and take steps to protect your future.

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