The sequence of returns – the greatest risk to your retirement savings – refers to the timing or sequence of when positive and negative investment portfolio returns occur. We believe it is in the retiree’s best interest to understand this phenomenon as it can be one of the greatest threats to their retirement savings.
Why is Sequence of Returns Risk Such a Threat to Retirement Savers?
For those of you approaching or in retirement, you are in what we would call the “preservation stage” of retirement, and soon to be approaching the “distribution phase” of retirement – when you start to live on your hard-earned savings.
For the past several decades leading up to retirement you have been in the “accumulation phase”. All three of these “phases” are vastly different – a concept that most retirees misunderstand.
The main reason why sequence of returns risk – which we will refer to as “SOR” for short – remains such a significant threat, is that most retirement savers go straight from the accumulation phase to the distribution phase and completely remit the planning in-between.
The “in-between” is the preservation phase, and as a retiree it has everything to do with your retirement saving’s future success.
The most important concept to understand is that there comes a point where when (or the sequence in which) your money performs can be just as important as how well your money performs. That point is the distribution phase. Therefore, retirees should begin focusing on account balances, not just investment performance.
“Retirees should begin focusing on account balances, not investment performance.”
As you will see in the accumulation phase there actually is no SOR risk, but in the distribution phase it can be detrimental to your retirement income and savings. Let’s start by explaining the differences between these phases.
Accumulation Phase – Sequence of Returns Doesn’t Matter
During this time in your working years you are likely socking money away hoping that one day it will grow to a large nest egg that can support you, and possibly a spouse, for a long and prosperous retirement.
Over the years you will surely have had bouts of great investment performance, and some periods of poor performance. However, when you experience those ups and downs doesn’t necessarily matter.
Here is a simplified example:
Example: Accumulation Phase Portfolio Returns
| $100,000 Portfolio (no additions) | ||
| Return | End of Year Balance | |
| Year 1 | 40% | $140,000 |
| Year 2 | 20% | $168,000 |
| Year 3 | 0% | $168,000 |
| Year 4 | -15% | $142,800 |
| Year 5 | -20% | $114,240 |
Now, reverse the order of returns
| $100,000 Portfolio (no additions) | ||
| Return | End of Year Balance | |
| Year 1 | -20% | $80,000 |
| Year 2 | -15% | $68,000 |
| Year 3 | 0% | $68,000 |
| Year 4 | 20% | $81,600 |
| Year 5 | 40% | $114,240 |
This timing of when positive and negative returns occur is called the sequence of returns and it does not matter in the accumulation phase. The ending balances in each scenario are exactly the same.
The ride on the way to a sufficient nest egg can be nerve wracking at times, but it ends up in the same place.
Now let’s look at the distribution phase and why it is so different.
Distribution Phase – Sequence of Returns Matters
During the distribution phase you are ready to crack your nest egg or inheritance and begin to live off the income it can provide.
In today’s world, with the lack of guaranteed pensions provided by employers, it is becoming more important for your nest egg to provide you and your spouse sufficient income for a potential 20-30 year retirement – Not to mention the ever-increasing cost of goods and services, a.k.a. inflation!
Of equal importance, is making sure that nest egg is somewhat accessible (liquid), in case you need to tap into it for large unforeseen expenses. Who has those?
The distribution phase of course will also have periods of great investment performance and some poor. However if the preservation and planning phase is skipped, when you experience those ups and downs ABSOLUTELY MATTERS.
Here is a simplified example, piggybacking off the last:
Example: Distribution Phase Portfolio Returns
| $100,000 Portfolio | ||||
| Return | End of Year Balance | Withdrawals | Remaining Balance | |
| Year 1 | 40% | $140,000 | ($6,000) | $134,000 |
| Year 2 | 20% | $160,800 | ($6,000) | $154,800 |
| Year 3 | 0% | $154,800 | ($6,000) | $148,800 |
| Year 4 | -15% | $126,480 | ($6,000) | $120,480 |
| Year 5 | -20% | $96,384 | ($6,000) | $90,384 |
Now, reverse the order of returns
| $100,000 Portfolio | ||||
| Return | End of Year Balance | Withdrawals | Remaining Balance | |
| Year 1 | -20% | $80,000 | ($6,000) | $74,000 |
| Year 2 | -15% | $62,900 | ($6,000) | $56,900 |
| Year 3 | 0% | $56,900 | ($6,000) | $50,900 |
| Year 4 | 20% | $61,080 | ($6,000) | $55,080 |
| Year 5 | 40% | $77,112 | ($6,000) | $71,112 |
As you can see in the distribution phase – when you begin to live on your hard-earned savings – the sequence of returns absolutely matters, and it matters a lot!
How would you feel if you ended up in a situation such as the last scenario, and had only half your portfolio left ($50,900) in just 3 years? Stressed a little?
This phenomenon further increases portfolio risk because investors are emotional, and emotions and investing don’t mix. This leads to irrational investment decisions and often leads to a deteriorating retirement portfolio, ultimately causing retirees to outlive their money.
One example of an irrational investment decision would be selling stocks at a low point (year 3 in our example), not having a plan to get back in the market, and therefore eliminating the potential to gain your money back!
Case Study
For an even better understanding, let’s look at an interesting case study using two retirees to help further illustrate this phenomenon:
Retiree #1: Raymond, Age 65
Raymond retired in 1969 with a $100,000 nest egg invested in a 60% stock / 40% bond portfolio*.
Raymond withdrew $8,000 per year for the next 30 years to supplement his retirement income.
By the year 1993 Raymond’s nest egg had completely run dry leaving him 5- 6 years short on income, no money for unforeseen medical expenses, and nothing to leave to his spouse or heirs.
However, during the 30-year period from 1969 through 1998, that portfolio had an average annual return of 11.78%.
Retiree #2: Diana, Age 65
Diana retired in 1979 with a $100,000 nest egg invested in the exact same 60% stock / 40% bond portfolio*.
Diana also withdrew $8,000 per year for the next 30 years to supplement her retirement income.
Here’s where things get interesting…
Not only did Diana not run out of money, but by the end of the year 2008 (30 years later and during the Great Recession), Diana had a remaining account balance of $874,813!
How could this be possible?
This is because she started her withdrawals in 1979 vs 1969 which was drastically different in terms of the portfolio’s performance.
The portfolio had several great years of returns right out of the gate as she started to take distributions from her portfolio – This is when sequence of returns matters!
Raymond’s timing was obviously not so lucky.
He had experienced numerous market downturns shortly after retiring while also taking withdrawals that further hurt his portfolio’s return in down market cycles.
It doesn’t stop there…
During the 30-year period from 1979 through 2008, that portfolio had an average annual return of 11.20%! Nearly the same as the period from 1969 through 1998!
In this case study we see the drastic effects that sequence of returns risk can have on a retiree’s finances and that average annual returns don’t tell the whole story. In fact, Diana had a lower average annual return than Raymond!
Although it may seem farfetched or counter intuitive, lower returns can still lead to better results.
The key is that retirees shouldn’t focus entirely on the returns of their investments in retirement. Instead, they should focus more on their account balances over time, and strategies to maintain them as much as possible.
*Based upon data represented by the annual returns of the S&P 500 for stocks, and the 10-Year treasury-bond respectively for the 30-year periods 1969-1998 and 1979-2008 with $8,000 annual withdrawals.
The Preservation Phase – The Solution
This phase is when you take the time to recognize that you are going from saving to spending. As you have learned it is not efficient to jump straight from one to the other. This is because of potentially devastating hazards like sequence of returns risk, high taxes, or unforeseen expenses.
During the preservation phase, careful planning must be coordinated to address the above issues. This can be accomplished numerous ways, some far simpler than others.
First you must have a plan or set of goals in mind for your money. Only then should you formulate a strategy to help you reach those intended goals. Your strategy should be implemented during this preservation phase!
Strategy for Mitigating Sequence of Returns Risk
At a high level, one example strategy could be breaking down your nest egg into different “buckets”, “boxes”, “sleeves”, etc. that each serve a specific investment purpose.
This strategy alone can solve most of the issues previously discussed if done correctly and followed prudently.
One remaining issue is figuring out a way to remove your emotions from the investment plan, this may be where you start to consider having a financial planner or money manager take over.
If you took the $100,000 nest egg in Raymond’s scenario in 1969, and broke the account up into buckets, here’s what that might look like:
Now
In this simplified version of a bucketing strategy, the “NOW” bucket would set aside money Raymond will need for the next 12 months, as well as money he may need in case of an emergency – or a large planned expense.
This bucket also positions him to mitigate sequence of returns risk while he begins withdrawing from his portfolio. This is because he can make sure he has the cash on hand now when the market is not in a significant downturn.
This prevents Raymond from liquidating stocks to generate cash after they have dropped in value, further damaging the portfolio.
Soon
In the “SOON” bucket, Raymond can reallocate 5-10 years’ worth of income into less volatile investments that aren’t likely to participate in large swings.
This bucket has the goal of generating returns to keep up with inflation and hopefully earn more than a bank account.
Every 1 to 2 years this bucket refills the income portion of the cash “NOW” bucket depending on your specific needs.
Later
The remaining “LATER” bucket is just as important as the “NOW”. This bucket is out of sight, out of mind.
This bucket has the goal of growing significantly and outpacing inflation over a long period of time (i.e. 10+ years). It has the ability to do so by being invested in growth-oriented investments.
The types of investments in this bucket will likely carry significantly greater volatility compared to the other buckets.
Time, compound interest, purpose, and the fact that this bucket is in growth-oriented investments will allow Raymond to solve many of his potential issues.
Raymond won’t have to worry about the inevitable emotional decision making that comes with a dying account balance. This helps eliminate irrational investment behavior! Hooray!
This bucket is not subject to annual withdrawals by Raymond which helps preserve its growth potential.
He will have a bucket that can not only refill his “SOON” bucket in good times, but also gives him the potential to leave his spouse with an income producing asset so she isn’t left in the dust if he predeceases her.
The “LATER” money can also allow him to increase his income over time due to the effects of inflation and give him an access to a lump sum amount for major medical expenses late in life.
This strategy can be implemented in many ways and can incorporate multiple accounts, multiple retirees, or even used for managing inheritances.
The Bottom Line
- As you can imagine there is much more that can be done depending on your situation and any strategy implemented must also play well with other areas of your financial life (i.e., taxation, Social Security, Medicare, legacy planning). While these concepts are simple in theory, they are far more difficult in practice.
- Retirees should begin focusing on account balances, not just investment performance.
- Start a conversation sooner than later with your advisors to get off on the right foot, or feel free to reach out to us. Tax-efficient retirement income planning is our specialty.
Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ located in Riverside and Orange County, CA.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.
The hypothetical examples are for illustration purposes only and not intended to be representative of actual results or any specific investment, which will fluctuate in value. The determinations made by the examples are not guarantees or projections, and no taxes or fees/expenses are included in the calculations which would reduce the figures shown.
Please keep in mind that it is possible to lose money by investing and actual results will vary.