24 Jul Sequence of Return Risk Explained

Sequence of Return Risk Explained

By: Noah King, Intern

If you follow any talking heads online, you might have heard the term “sequence of return risk.” It can be worrisome for retirees and those quickly approaching that life milestone. In this article, we’re going to talk about what it is, why it matters, and what you can do about it. 

What is it?

Sequence of return risk refers to the danger of experiencing a negative market year early on in your retirement. If you rely on withdrawals from your investments, an early market drop can materially reduce long-term portfolio value. The reason for this is because when the market is low, you have to take out more shares to meet your yearly expenses. Even when the market recovers, you have fewer shares invested since you had to liquidate them at the lower price. 

For example, say you spend $50,000 a year in retirement. If you have shares priced at $1,000, you’d only need to take out 50 shares. However, if the market drops and those shares are now worth $750, you need to take out ~67. Even if the share price rises back up to $1,000, you now own fewer shares than before, and therefore your portfolio has less opportunity to recover. 

Below is a hypothetical illustration that illustrates how the sequence of returns risk looks  in a real portfolio. Both investors start with $1,000,000, withdrawal $50,000 a year, and have the same average annual return. However, the timing of the annual return that they get is reversed. We can see that in Scenario B, the ending balance is significantly lower even though they had the exact same annualized return as scenario A over the course of the entire retirement.

Illustrative examples: The examples shown below are hypothetical and are provided solely for educational purposes. It does not represent the performance of any actual client or portfolio. Actual investment results will vary and may be materially different depending on market conditions, investment allocations, fees, taxes, withdrawal timing, inflation, and other factors.

The chart below illustrates that, without the withdrawals, the two portfolios would have the exact same ending balance at year 2045.

So how do we prevent it?

While there is no way to truly “prevent” the risk, we can find ways to mitigate the damage that we take in down years. There are a variety of ways to do this, each ensuring that no matter the market, you can feel confident in your retirement plan. 

Our first way to mitigate risk is by holding about 1-3 years of expenses in an easily liquidated form. Two of the easiest ways to do this is to hold it simply as cash, or to hold it in bonds. By doing so, instead of withdrawing from your stock portfolio in a down year, you can instead use your cash or bond holdings to cover your expenses. This may help provide a buffer against down years, and when the market is up you can refill the buffer. The reason this works is because the primary cause of the significant loss is the withdrawal, not the market.  This strategy may reduce the likelihood that you will need to sell equities during market downturns.

Another way is to implement a dynamic withdrawal strategy. When the market is low, you withdraw less to ensure you don’t take on as much of the loss. On the flip side, when the market is up you withdraw more to balance it out. This may allow more assets to remain invested during market recoveries.

Finally, you can use any income you make (from social security, a pension, etc) to fund basic necessities (food, housing, utilities, etc), while withdrawals are used to fund purchases such as travel or other non-essential expenses. The reason this works is because, again, the main damage of the sequence of return risk comes from the withdrawal. By minimizing how much you withdraw, you allow your portfolio to recover closer to what it was before the down year.

To Summarize

Two retirees can start with the exact same portfolio balance, withdraw the same amount, and have the same average annual return, but end up in completely opposite positions. The difference comes from the sequencing of events. The retiree who sees good years immediately after retiring can end up with hundreds of thousands of dollars more compared to a retiree who sees down years early on. The kicker is that this was caused by nothing but bad luck!

The sequence of return risk is a lesser known, and a harder to anticipate challenge that many retirees face. This is primarily because some of the risk comes from how the market performs, which is out of our control. 

Although the sequence of return risk can feel scary and inevitable, there are strategies that may help reduce the impact. While we can’t change the market, we can change our withdrawal amounts and how we prepare for down years. If you’re a Wright Wealth client, we are already doing this for you. The strategies include keeping a cash buffer and having a withdrawal plan that includes five to seven years of bonds before we ever have to think about touching your stocks. We also run simulations that include sequences of down markets in our retirement planning process.  Please let us know if you have any questions about this or anything related to your financial plan.

Information is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products, or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this post (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of Angela Wright, an Investment Adviser Representative of Gemmer Asset Management LLC (“GAM”) and should not be regarded as the views of GAM, or a description of advisory services provided by GAM or performance returns of any GAM client.  References to securities or market-related performance data are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.  

The information presented herein may contain links to third party websites with which we have no affiliation. A link to any third-party website does not mean that we endorse it, or the quality or accuracy of the information presented on it.

This material is provided for informational and educational purposes only and is not intended as investment, tax, legal, or accounting advice or as a recommendation to buy or sell any security. The examples and illustrations presented are hypothetical and are intended solely to demonstrate financial planning concepts. They do not represent the performance of any actual client account, and actual results will vary. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. There is no guarantee that any investment strategy, including maintaining cash reserves or fixed-income allocations, will be successful or achieve its intended objective. Investment recommendations should be based on an individual’s objectives, financial situation, and risk tolerance.