65% of retirees who experience a significant market downturn in the first five years of retirement will outlive their assets, despite having an average annual return of 7%.
Understanding Sequence of Returns Risk
Sequence of returns risk refers to the impact of the order in which investment returns are realized on the sustainability of a retirement portfolio. Two retirees can have the same average annual return, but if one experiences negative returns early in retirement, they are more likely to run out of money.
For example, consider two retirees, John and Jane, who both start with a $1 million portfolio and plan to withdraw $50,000 per year, adjusted for inflation. They both expect an average annual return of 7%. However, John experiences returns of -10%, 5%, 10%, 8%, and 12% in the first five years, while Jane experiences returns of 12%, 10%, 8%, 5%, and -10% in the same period.
A Concrete Example of Sequence of Returns Risk
Despite having the same average return, John's portfolio will be depleted after 25 years, while Jane's portfolio will last for 30 years. This is because John's negative returns in the early years reduced his portfolio's value, leaving it more vulnerable to subsequent withdrawals.
The first five years of retirement are critical because they set the tone for the rest of the retirement period. A significant market downturn during this time can have a lasting impact on the sustainability of the portfolio.
Mitigating Sequence of Returns Risk
To mitigate sequence of returns risk, retirees can consider using a bond ladder or other investment strategies that provide a steady income stream. They can also use tools like the Freedom Calculator to stress-test their retirement plans and identify potential vulnerabilities.
Managing Retirement Risk
Managing retirement risk requires a comprehensive approach that takes into account various factors, including sequence of returns risk, inflation, and longevity. Retirees should regularly review their portfolios and adjust their strategies as needed to ensure they are on track to meet their retirement goals.
The key takeaway is that the order of returns matters, and the first five years of retirement are the most critical. By understanding sequence of returns risk and taking steps to mitigate it, retirees can increase their chances of a successful and sustainable retirement.