Stepping into retirement is like setting sail on a grand voyage. Just as a sailor can’t control the sequence of storms and calms on the open sea, retirees can’t control the sequence of investment returns. And just as one major storm can change a sailor’s course forever, so too can a poorly timed downturn in the market deeply impact a retiree’s financial journey. This phenomenon is known as the ‘sequence of returns risk.’ Understanding this risk is a linchpin for anyone prepping for retirement.
What is the Sequence of Returns Risk?
Simply put, it’s the risk arising from the order or sequence in which your investment returns occur. While you’re working and contributing to your savings, the market’s ups and downs average out over time with little long-term impact. However, as you near retirement or when you begin withdrawing funds during retirement, a market downturn can create a heavy blow to your finances.
A Tale of Two Couples
Let’s step into the world of two hypothetical couples, John and Jane and Rob and Rachel, to see this risk in action.
Both couples have saved the same amount for retirement and are ready to start their golden years. They both plan to withdraw the same fixed sum annually.
John and Jane begin their retirement when the market is thriving. They enjoy high returns for the first several years. By the time the market dips, they’ve withdrawn only a tiny portion of their savings, and their investments have grown significantly. Even with later years seeing lower returns, the early high returns bolster their portfolio.
On the flip side, Rob and Rachel aren’t so lucky. They retire during a market slump. With low returns and regular withdrawals, their portfolio shrinks rapidly. When the market starts to climb, their savings are so diminished that even high returns can’t compensate for their early losses.
Now, let’s add a twist. Imagine reversing the sequence of returns for both couples. John and Jane, who started well, would now face the challenges Rob and Rachel did, and vice versa. This simple switch reveals the profound impact the sequence of returns can have.
The Vulnerability of Investment Portfolios
While IRAs and 401ks are famous vessels for retirement savings, they don’t offer protection against a sequence of returns risk. A downturn in the market just as you begin drawing on these funds can mean drastically reduced income in your retirement years.
Secure Your Sail
As you plan for retirement, it’s essential to factor in strategies to mitigate the sequence of returns risk. Whether diversifying investments, reconsidering withdrawal rates, or revisiting your retirement timeline, it’s crucial to have a flexible plan.
Remember, while we can’t predict the markets, we can prepare for their unpredictability. By understanding the sequence of returns risk and working with a financial strategist, you can set sail into retirement with a fortified vessel, ready to weather any storm and enjoy calm seas alike.
