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 Couples: An Illustrative Example
To truly grasp the essence of this risk, let’s consider a hypothetical scenario involving two couples—let’s call them Alice and Bob, and Emily and Mark.
Both couples have identical savings and investment plans, and both plan to withdraw an equal amount annually for their expenses.
Scenario 1:
Alice and Bob: They kick off their retirement years on a high note. The market is robust, their portfolio is strong, and their initial years see excellent returns. They comfortably make their planned withdrawals without denting their corpus. Even when the market eventually takes a dip, the effect is cushioned by the solid initial growth.
Emily and Mark: They aren’t as lucky. Their retirement coincides with a bear market. Their investments take a hit right when they start making withdrawals. Even when the market improves, the early losses have already done lasting damage, and their portfolio never fully recovers.
Scenario 2:
Now, let’s reverse the sequence of returns for both couples. Alice and Bob now start their retirement with poor returns, and Emily and Mark get a strong start. The pair’s fortunes would flip completely, demonstrating just how impactful the sequence of returns can be.
The Fallibility of Standard Investment Portfolios
It’s crucial to understand that traditional retirement savings vehicles like your 401k or IRA do not provide immunity against this risk. A poorly timed market downturn could severely hamper the longevity of these investments when you start making withdrawals.
Mitigation is Key
Given the unpredictable nature of the market, the focus should be on taking steps to mitigate this risk. This could include diversifying assets, tweaking withdrawal rates, or reevaluating the retirement timeline based on market conditions.
Wrapping Up
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.
