What happens if you encounter negative investment returns early in retirement?

Clearly, there is a lot to think about when planning for retirement. While we have a degree of control over many of the choices involved, there’s one big wild card called sequence of return risk.

Sequence of return risk is the risk that you’ll encounter negative investment returns in early retirement. This is an important consideration, because the sequence – or order – in which you earn your returns early in retirement can have a significant impact on your lasting wealth. Simply put, a retirement portfolio that happens to experience positive returns early in retirement will outlast an identical portfolio that must endure negative returns early in retirement. This is true even if the long-term rate of return for both portfolios are identical.

Since nobody can predict which return sequence they’ll experience early in their retirement, every family should prepare for a range of possibilities in their retirement planning.

The Significance of Sequence of Return Risk

It’s no secret that global stock markets are volatile. While long-term average annual returns may be in the range of 7% for a diversified portfolio of global stocks and bonds, markets rarely deliver average returns in any given year. Rising one year, falling the next; we never know for sure how far above or below the average each year will be.

During your career, you’re mostly spending earned income, while adding to your retirement portfolio. As long as you stay the course benefiting from the upswings and enduring the downturns – tolerating market volatility is just part of the plan.

In fact, when you’re still accumulating wealth, market downturns give you the opportunity to buy more shares than you otherwise could when prices are higher. When the market recovers, you then have more shares to recover with, which ultimately strengthens your portfolio.

But then, you stop working, and start spending your reserves. This has the opposite effect. Now, when the stock markets decline, you may need to make a withdrawal from a portfolio that has declined in value. This underscores the need for a broadly diversified asset allocation of stocks and bonds. When stocks are down, we want to source withdrawals from the part of the portfolio that has maintained its value. Selling an asset when it is down, means you will have fewer shares with which to participate in the eventual recovery. This hurts your portfolio’s staying power.

Sequence of return risk Illustrated

Consider two hypothetical retirees, Joan and Jane:

  • Both retire at age 65 with identical $1 million dollar stock portfolios.
  • Both start withdrawing $50,000 annually at the start of each year (not adjusted for inflation).
  • Both earn the same 7% average annual returns over their 25 years in retirement.

With so much in common, you might assume their portfolios would perform similarly. But what if Joan happens to enter into retirement during a horrible market? Let’s imagine her portfolio returns –30% and –20% in her first two years, while Jane earns 7% both years, and (implausibly) every year thereafter.

Markets recover nicely for Joan after two years so, again, she ultimately earns the same average 7% annual return as Jane. But Sequence of return risk takes a heavy toll on Joan’s remaining shares. She ends up with only about $150,000, while Jane’s portfolio grows nicely to around $2 million.

Illustration, not indicative of an actual investment allocation
Portfolio is hypothetical and exaggerated to demonstrate impact of volatility.
Source: Wendy J. Cook Communication, LLC

Managing the Sequence of return risk Wild Card

Sequence of return risk should NOT change your overall approach to investing. As the recent past has clearly shown us, you never know what’s going to happen next. Stock market corrections typically occur
without warning, while some of the strongest rebounds arrive amidst the darkest days.

So, whether you’re 40, 60, or 92, we still recommend building and maintaining a low-cost, globally diversified portfolio that reflects your personal goals and risk tolerances. We still advise against trying to pick individual stocks or react to current market conditions. We still suggest you only change your portfolio’s asset allocations based on life events, not market events.

What can you do to mitigate Sequence of return risk if it happens to you?

Keep working. If you are willing and able, you might postpone retirement, or even return to the workforce. Even part-time employment can help offset an ill-timed sequence of negative market returns.

Spend less. Since your portfolio is most vulnerable to negative sequence of return risks early in retirement, you may want to initially spend less than planned, to give your portfolio an opportunity to rebound.

Tap other assets. When you retire, you typically have several sources of income to draw from. You may have emergency cash reserves, Social Security, or pension plans. Your investments are usually divided
between stocks and bonds. You may have equity in your home. If you encounter a negative stock market in retirement, you might be able to tap a combination of your non-stock assets for initial spending needs.

Consult with a financial advisor. Sequence of return risk is usually not the only consideration at play in retirement planning. There are taxes to consider and estate planning goals to bear in mind. There are carefully structured investment portfolios to maintain. All these needs speak to the value an experienced advisor can add before, during, and after this pivotal time in your financial journey.

At Conrad Siegel, we help our clients prepare for and mitigate Sequence of Return Risk within the greater context of their goals for funding, managing, spending, and bequeathing their lifetime wealth. Please be in touch today if we can help you with the same.

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