Sequence of Returns
The Stock market doesn't care when you retire!! prepare for best - plan for the worst....
Sequence of Returns refers to the order in which investment returns occur over time. It becomes especially important during the withdrawal phase of a portfolio (like retirement), as the timing of positive and negative returns can significantly affect how long your money lasts — even if the average return stays the same.
Key Concepts:
1. Accumulation Phase (When You're Saving):
- The sequence of returns does not matter much.
- What matters is the average rate of return over time.
- Whether you get bad returns early or late, your final portfolio value will be about the same.
2. Withdrawal Phase (When You're Retired):
- The sequence of returns matters a lot.
- Bad returns early in retirement, when you are also making withdrawals, can deplete your portfolio faster.
- This is known as sequence of returns risk.
Example:
Let’s say two retirees start with $1 million and withdraw $50,000 annually. Both have an average return of 5% over 30 years, but:
- Retiree A has strong returns early, then weak returns later.
- Retiree B has weak returns early, then strong returns later.
Even though their average return is the same, Retiree B may run out of money much sooner than Retiree A because the early losses plus withdrawals reduce the base too quickly.
Why It Matters:
- Retirees and pension funds must be particularly careful about sequence risk.
- It’s why safe withdrawal strategies, diversified portfolios, and annuity products can be useful.
- Mitigation strategies include:
- Reducing spending in down years.
- Using a bucket strategy (short-term cash, medium-term bonds, long-term stocks).
- Building a buffer with guaranteed income (like Social Security or annuities).
*** Below is an example of Ted, who is taking out $25,000 per year in retirement. What Ted, or any of us for that matter, doesn't know, is what kind of market we will retire into!!
In this case the market is down the first 3 years. Combine this with his $25,000 withdrawals and it becomes a snowball effect on his account. Even with some up years, his account can't get back on track and when another big down year hits, it makes it almost impossible.
In this example, by continuing to withdraw $25,000 per year, this account runs out in year 18. Of course in real life, Ted would either start withdrawing less, change his lifestyle, or both - probably both, because one leads to the other.
How does this affect you?
You need to be aware of the risk you take if your are 100% in the stock market. This means your retirement is 100% dependent on what the market does.
Are you prepared to take on that kind of risk at this stage of your life?
There are good options to mitigate some of your risk. Guaranteed Lifetime Income Annuities!
Ted is withdrawing $25,000 per Year but his retirement starts on a sour note. This is the effect
Sequence of Returns
You don't know what kind of market you are going to retire into!
Sequence of Returns refers to the order in which investment returns occur over time. It becomes especially important during the withdrawal phase of a portfolio (like retirement), as the timing of positive and negative returns can significantly affect how long your money lasts — even if the average return stays the same.
Key Concepts:
1. Accumulation Phase (When You're Saving):
- The sequence of returns does not matter much.
- What matters is the average rate of return over time.
- Whether you get bad returns early or late, your final portfolio value will be about the same.
2. Withdrawal Phase (When You're Retired):
- The sequence of returns matters a lot.
- Bad returns early in retirement, when you are also making withdrawals, can deplete your portfolio faster.
- This is known as sequence of returns risk.
Example:
Let’s say two retirees start with $1 million and withdraw $50,000 annually. Both have an average return of 5% over 30 years, but:
- Retiree A has strong returns early, then weak returns later.
- Retiree B has weak returns early, then strong returns later.
Even though their average return is the same, Retiree B may run out of money much sooner than Retiree A because the early losses plus withdrawals reduce the base too quickly.
Why It Matters:
- Retirees and pension funds must be particularly careful about sequence risk.
- It’s why safe withdrawal strategies, diversified portfolios, and annuity products can be useful.
- Mitigation strategies include:
- Reducing spending in down years.
- Using a bucket strategy (short-term cash, medium-term bonds, long-term stocks).
- Building a buffer with guaranteed income (like Social Security or annuities).
impact of sequence of returns
Here's the chart showing the impact of sequence of returns using actual S&P 500 total returns from 2000 to 2019:
· Blue Line: Returns applied in their original order.
· Orange Line: Returns applied in reverse order.
Even though both scenarios use the exact same 20 years of returns, the ending balances differ significantly — solely due to the order of returns. This illustrates how vulnerable retirees can be to bad market years early in retirement when making withdrawals.