So you finally reached retirement which you worked so hard to achieve all your life. You have accumulated what you believe is an ample nest egg and you think you are home free to live out your retirement lifestyle by withdrawing 4% annually from an established 60% stock and 40% bond investment strategy. Think again, there is a significant risk retirees need to consider and mitigate. The risk is known as sequence of returns risk, which is of greatest importance to retirees who have just entered retirement.
Sequence of returns risk is all about how returns for a given household investment strategy are received over time or the order in which investment portfolio gains and losses occur over time. Uniformity in returns is unlikely over time so earning an average 9% return each year throughout your retirement is not a reliable assumption. It is more likely that you will see variation in the pattern of returns you receive over time which may trend toward an average 9% over a long term investment horizon of perhaps 30 to 40 years.
Depending on the timing of your retirement, you may be entering retirement during a time when the stock market or economic cycle is trending higher where you may earn returns of 10%, 15% or even 18% for the first three years of retirement. Great news! However, you may also enter retirement when you incur losses of (20%), (10%) or (5%) in the first three years of retirement. Not great news and what we might call bad timing!
Taking withdrawals from the portfolio when the market value reflects a loss amplifies the negative impact to the portfolio by realizing not only the withdrawal amount as a permanent loss but also the losses realized on securities sold to fulfill the withdrawal need. Now the retiree’s investment portfolio needs to recover from both market losses and the periodic withdrawals created along the way.
Realized losses on a retirement portfolio early into retirement are very difficult to if not impossible to regain. The portfolio is in a downward trend with periodic withdrawals where losses become permanent. In some cases, the security losses realized early into retirement require an immediate reduction to the investment rate of withdrawal from the portfolio to continue to track long range sustainability goals otherwise you risk spending through the investment portfolio a lot sooner than anticipated.
So how might we help reduce sequence of returns risk?
Working longer and saving more can help to provide more funds for retirement. Of course if you are already retired you may not happily receive this advice.
Delaying the election of Social Security benefits can help to increase fixed or guaranteed sources of retirement income later into retirement which can relieve the stress on the investment portfolio with less portfolio withdrawal needs later into retirement.
Building and implementing a disciplined investment strategy for retirement withdrawals which attempts to match lower risk investments with anticipated withdrawal needs for a number of years into retirement can help to mitigate sequence of returns risk. Even if longer term securities at times reflect a loss, designated shorter term securities are available to help meet withdrawals for a period of time allowing for the possibility of longer term securities to regain value before being needed for withdrawal.
Overall the goal is to set into place a disciplined investment distribution strategy for retirement before you retire. In the unlikely event you retire just prior to a bear market decline having an established investment distribution plan set into place with identified securities earmarked for anticipated withdrawals for a number of years into retirement can help to mitigate sequence of return risk.