Retirement, for many, is a well-deserved reward after years of hard work and financial discipline. But it’s also a stage of life that comes with its own set of financial complexities. One significant but often under-recognized hazard is the sequence of returns risk. In this blog post, we will explore a crucial aspect of retirement planning: understanding and mitigating risk.
What Exactly is Sequence of Returns Risk?
Simply put, the risk comes from how your investment returns happen. During your working years, if you’re regularly contributing to your savings, the order in which you get your returns doesn’t make a drastic difference in the long run. Market ups and downs average out. However, the timing can significantly impact when you’re about to retire or have just entered retirement and are starting to withdraw from your savings.
A Tale of Two Siblings: An Illustrative Example
To truly grasp the essence of this risk, let’s consider a hypothetical scenario involving two siblings Bill and Jill.
Both were able to accumulate identical savings and investment plans while working, and both plan to withdraw an equal amount annually for their expenses.
Scenario 1:
Bill, who retires in 1996: He kicks off retirement years on a high note. The market is robust, his portfolio is strong, and their initial years see excellent returns. He comfortably makes his planned withdrawals without denting his nest egg. Even when the market eventually takes a dip, the effect is cushioned by the solid initial growth.
Jill, who retires three years later in 1999: She is not as lucky. The early years of her retirement coincides with a bear market. Her investments take a hit right when she starts making withdrawals. Even when the market improves, the early losses have already done lasting damage, and her portfolio never fully recovers.
Scenario 2:
Now, let’s reverse the sequence of returns for these siblings. Bill now starts his retirement with poor returns, and Jill gets a strong start. Their fortunes would flip completely, demonstrating just how impactful the sequence of returns can be.
Watch the short video below which clearly explains how Sequence of Returns Risk works.
The Fallibility of Standard Investment Portfolios
Traditional retirement savings vehicles like your 401k or IRA do not immunize you against this risk. A poorly timed market downturn could severely hamper the longevity of your investments when you start making withdrawals. What you’ll have to live on is out of your control when you are invested in the market.
Mitigation is Key
Given the unpredictable nature of the market, your focus should be on mitigate this risk. This could include diversifying assets, tweaking withdrawal rates, or reevaluating your retirement timeline based on market conditions.
Develop a Risk Mitigation Strategy Sooner Rather than Later
The sequence of returns risk is an often-overlooked but critical aspect of retirement planning. Understanding this risk and developing a comprehensive strategy to mitigate its effects can be your safeguard against unforeseen challenges in your golden years. As you sail toward the horizon of your retirement, make sure you’re equipped to navigate through both calm and turbulent financial waters.Siblings
