"Sequence Of Returns Risk", And Why It Matters

As you develop your financial plan for retirement you will give a good deal of thought to the known details of your finances (e.g., monthly expenses, income, etc.) as well as to what you expect to happen in the future. One particularly important decision concerns the annual rate of return that you will use to forecast your savings/investments balances. Since you can't predict the future, you may end up relying on your (not the market's) historical results to arrive at a reasonable expectation. That makes sense, but how you choose to enter that information can have a serious effect on your results. If you expect a 5% return overall, entering a 5% return for every year may not be the best idea. We'll explain the pitfalls of doing this in more detail in our next blog post, but the bottom line is that using a variety of higher and lower return rates, that still average 5% overall,  may prove to be more realistic than smoothing the results out to mimic an average historical return for every year. For example, $1M earning 9.11% for every year for 20 years (the S&P historical average for the past 20 years) would result in $5.7M. Using the actual S&P results for every year for the same 20 years results in $4.3M. The convenience of entering the same rate of return for all years rather than taking a few minutes to enter varying returns is not worth the possibility of overestimating the growth of your savings by 30%!

There is also another consideration that comes into play. It's not just varying the yearly return rate that's important,
it's also the timing of those returns. There is a term called, "Sequence Of Returns Risk", that should play a key role in
your planning process. The "risk" refers to the fact that the order in which you receive your returns is just as critical as the returns themselves.

This only becomes a factor in retirement, once you start taking distributions. Before retirement, your balance is only affected by the rate of return, so the order in which the returns arrive doesn't matter. The end result is what it is.
But once distributions start, the order of returns plays a key role in the growth of your savings, and it can be quite impactful. Let's assume that you start with $1M, take a $50,000 distribution each year, and earn the following returns:
Year 1    25%
Year 2      8%
Year 3    10%
Year 4   -15%
At the end of 4 years your balance would be $1,072,510.

Now use the same assumptions, but reverse the sequence of returns:
Year 1    -15%
Year 2     10%
Year 3       8%
Year 4     25%
At the end of 4 years your balance would be $1,008,000.

The overall/average rate of return is the same in both examples (7%), but the difference in the ending balances
is $64,510 - in only 4 years! Over 20 years that could potentially amount to more than $320,000.
Clearly, the sequence of returns matters.

While you never want to lose money, experiencing a market downturn, particularly at the beginning of retirement, and having to take disbursements at the same time, is a double whammy that may be hard to recover from. While you have no control over your returns (other than diversifying your investments and limiting your risk to what you feel comfortable with), there are a couple of steps you can take to help mitigate the risk of "bad luck/bad timing".

First, stress test your financial plan by entering a variety of return rates over the years, even if they are in close proximity to each other, rather than using the same rate for all years.

Second, enter lower than expected return rates, and even some negative rates, right at the beginning of retirement and then in the middle of retirement. You are trying to find out how your savings would hold up over time with less than stellar results. Don't be afraid to create "the perfect storm". You can't predict the future, but you can be prepared for it.

Third, plan to keep several years of expenses in cash or very liquid accounts. Remember, the biggest risk of not achieving the return rates that you expect happens when you have to take money out of those accounts.

Lower than expected returns may hinder your progress, but lower than expected returns and lowering your balance at the same time will hurt far worse. Be sure to model the possible impact of sequence of returns risk, especially right before, or at the very beginning of, retirement. Expecting the unexpected will help to show just how well prepared you are for possible setbacks so that you can take any necessary steps to minimize the impact, and improve the odds of not outliving your savings.

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