If you are like lots of investors, you’ve probably never heard of sequence risk — also called sequence-of-returns risk — but it is a particularly pertinent concept for those nearing or just entering retirement.
Simply put: Sequence risk refers to the order or the timing in which your investment returns occur. It specifically relates to the risk of early declines and ongoing withdrawals impacting your spending during a certain period of time, most often in retirement.
It is this concept that helps explains why two retirees with the same wealth levels might not have the same retirement experience, even if their long-term return averages look the same.
An Example of Sequence Risk & Retirement
Let’s say your friend, Sam, retired five years ago with a $1 million nest egg and at the end of his first year in retirement and every year thereafter, he withdrew $50,000 per year as part of his annual income. If his nest egg grew 10% each year for the first three years, but dropped 5% each year for the next two years, at the end of five years his remaining nest egg would be $954,364. Overall, he weathered the two-year downturn fairly well.
Now, what if you retired with the same $1 million nest egg and you withdrew the same $50,000 each year, but your nest egg dropped 5% per year for the first two years and grew 10% per year for the next three years? Your remaining nest egg would be $905,955.
In this scenario, you didn’t fare as well as Sam. Overall, each person experienced the same amount of growth and the same losses, but your portfolio is $48,409 behind Sam’s results because of sequence risk—you experienced losses early in the five-year cycle.
This example illustrates how two retirees with the same wealth levels can experience different retirement results—sometimes significantly different results.
Consider the bad timing of a person who retired September 29, 2008, when the stock market fell 777 points, the largest single-day drop in history. While every investor faced the same drop that day, our newly retired individual had an added challenge. At some point, he must make a withdrawal for living expenses, and he must continue to make an annual withdrawal if he sticks with his retirement plan.
When you take withdrawals from your portfolio, instead of making contributions, the timing of gains or losses can make a significant difference in your overall results, despite long-term averages. The most critical time is right before or right after you retire—generally within a five-year period on either side of retirement. This period is so important because an early reduction in your nest egg could impact your future for years to come. That’s because you subject the portfolio to a double dip (returns and withdrawals) at the same time and that leaves less money to recover over the long term.
What Should You Do if You Encounter Sequence Risk?
First, don’t panic. You need to keep your assets invested to earn sufficient returns to maintain your retirement lifestyle. And trying to time market cycles is a nearly impossible task.
Fortunately, understanding the impact of sequence risk on your portfolio means you can take steps to diminish any potential negative impact. The crux of the sequence-risk challenge is the need to systemically drawdown assets—which is an element you can control through planning.
One potential solution is to build a retirement plan that incorporates some flexibility regarding how you obtain your annual withdrawal. For example, keep some funds – perhaps enough to equal at least one year’s withdrawal – in cash or cash equivalents, such as money market funds. This flexibility helps keep your investment portfolio on the same footing as other long-term investors during market downturns, which allows you to alleviate much of the significance of sequence risk.
Of course, every investor’s circumstance is different, so finding the most effective investment positioning is highly individualized. That’s where seeking advice comes in. If you are nearing retirement, it would be a good time to consult with a financial advisor regarding the asset mix in your investment portfolio. During your working years, you may have been primarily focused on investment growth, but you may now want focus on smoothing out volatility by taking a bit more conservative approach.
Remember, that does not mean abandoning the stock market because you are still a long-term investor—you could spend one, two or more decades in retirement, so you’ll still need a focus on growth to combat inflation and increase the longevity of your assets.