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The Unspoken Retirement Risk: Sequence of Returns

June 18, 2013
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Negative returns early in retirement can have a devastating long term impact. There are numerous studies on the impact of volatile market returns on your income from retirement savings. However, the sequence in which those returns happen can be the difference in barely making it through retirement or leaving a multimillion dollar legacy to your family. Despite these studies, I still see many traditional retirement income plans that utilize a constant average rate of return in their projections. This flat, no volatility average can lead pre-retirees and retirees to believe that they face minimal or no risk in funding their retirement. These conventional retirement plans completely exclude sequence of return risk and the impact of negative years early in retirement.
Suppose you need $50,000 in annual income from your investments. You have $1,000,000 in investments and you project a 6% average annual return which would give you that amount of income and still give you growth in order to adjust for the historical inflation rate of 3.6%. It appears on the surface like your investments can provide you with a retirement income that will maintain your standard of living and possibly maintain most of your original investment.

Unfortunately in the real world, market returns are not a constant 6%, rather they are not constant at all and can fluctuate significantly year to year. Let’s assume you have a portfolio that has an average annual return of 6%, with repeating series of returns - depending on when you retire you can get (+6, -13, +25) or (-13, +6, +25) or (+25, +6, -13).

Pre-Retirement The Sequence Of Returns is Irrelevant

During the accumulation phase the sequence of returns does not matter. When there are no withdrawals, a $1,000,000 initial investment after a 3 year cycle will always ends up being worth about $1,152,750 no matter what order the returns come.

At Retirement, Sequence Of Returns is Crucial

When you start retirement income the sequence of returns makes a significant difference in portfolio longevity. Assume you retire today at age 65 and you have a $1,000,000 portfolio and need $50,000 annually and want it adjusted for the historical inflation rate of 3.6%. The best sequence with the positive returns coming first, (+25, +6, -13), means your annual income will last until age 94. The worst sequence with the negative and smaller positive returns coming first, (-13, +6, +25), results in your portfolio being depleted at age 86. With life expectancies approaching the late 80’s, the difference of 8 years can be the difference between having enough and having to sacrifice when you need it most.

Consider a Real World Example

Let’s look at one of the more significant historical examples. Consider 3 individuals each retiring on January 1st in 3 consecutive years and each had a 30 year retirement. The first retired in 1962-1991, the second in 1963-1992 and the third in 1964-1993. Assume they each retired with $1,000,000 and withdrew $50,000 annually indexed to the average inflation. You might think that their balances would all be similar after 30 years of retirement. That makes sense when you see that the average annual rate of return for a balanced portfolio (60% Equity & 40% Fixed Income), over the past 60 years, was over 8% and the average inflation rate was 3.7% and you are only taking out 5% indexed to inflation.

This is not the case!

Because the first year of retirement for the individual that retired in 1962 was negative (remember withdrawals will amplify a negative return) and significantly different from the first year of retirement of the individuals the retired one and two years after, their ending value is surprisingly different.

The question boils down to how much of your retirement success or failure and how much of the legacy you leave to your family do you want to leave to chance?

The purpose of this article is not to be fatalist, but to point out that if you want to truly have a secure retirement you need to consider a plan that is tested and considers multiple tools to help you grow your income and account value over time, but that also protects a minimum income in the scenario that the market does not perform in your first years after retirement.

Bryon E. Townsend, CFP® is Managing Director at W.R. Anderson & Co, LLC a Houston, TX based financial planning firm. Securities and Investment Advisory services offered through Cetera Advisors LLC, member FINRA/SIPC. W.R. Anderson & Co is under separate ownership from Cetera Advisors. The information presented above is not intended to promote any specific investment vehicle nor any specific strategy. As well it is not intended to represent financial advice. All investing involves risk, including the possible loss of principal.  There is no assurance that any investment strategy will be successful.The calculations and charts were prepared from research by W.R. Anderson & Co. Registered branch address: 2190 N. Loop W., Ste 103 Houston, TX 77018