“Volatility casts an enormous shadow over your future financial plans. Economic shocks tend to arrive unexpected and unwelcome, seemingly out of nowhere, to turn your most solidly-imagined goals upside down.When the primary assets generating the most significant part of your retirement income get the worst returns at the worst time, you’re experiencing what’s called a “sequencing risk.”- Andrew Winnett.
By Andrew Winnett
As we’ve recently witnessed, economic shocks arrive out of nowhere, turning a solid market upside down. Such volatility can make a huge difference in enjoying a successful retirement. Unfortunately, if you happen to be cashing in your investments for retirement income while the market is crashing, you could find yourself with significantly less money than you need when you need it the most. Ultimately, the sequence of returns risk is the direct result not of poor planning but the inherently unpredictable nature of market returns.
Sequencing can affect anyone at any time.
Let me illustrate how sequencing risk could affect nearly anyone with retirement accounts who is ready to turn that money into income streams. While the scenario is fictional, Joe and Steve’s story illustrates how impactful sequencing risk can be when you no longer work.
Joe and Steve, both age 50, are life-long friends. They made plans to start a palm tree maintenance business after retiring from their current jobs. The two men managed to diligently save until each had around $100,000 in their retirement accounts. Each contributed about $20,000 a year into their accounts for nine straight years.
For the next nine years, Joe and Steve each experienced an average of 7% annual returns for their investments. Oddly, though, their individual accounts were noticeably different when retirement time came around because of the order in which they received their returns.
While Steve and Joe made nearly identical contributions and experienced the same average investment returns, they were shocked to see an over $77,000 difference in their account balances! This difference was due almost exclusively due to timing.
Joe and Steve’s account matrices were not identical. Nor did they cash their accounts in at the same time in the market cycle. Thus, even though they were doing things similarly, they experienced highly different outcomes.
Timing is everything when it comes to retirement. Sequence risk, unfortunately, is mainly a matter of luck. If you happen to retire during a raging bull market, your wealth may grow enough to offset any subsequent downturns. On the other hand, if you hit a bear market just as you enter the spend-down phase of your life, your account balances might never recover.
Besides the potential for having less income when you no longer work, sequencing risk could cause you to panic and make poor decisions in a bid to replace lost money. You might push yourself to play catch-up and take on riskier investments. If those investments lose money in or near retirement, you likely won’t have enough time to recover.
Another thing that might happen if your returns go negative shortly before retiring is that you might be forced to continue working, whether you want to or not.
What you can do to limit the impact of sequencing risk.
The sequence of returns risk is something that all pre-retirees and retirees must contemplate in their planning. While an element of pure luck is involved, your financial advisor can still devise a strategy to buffer the negative consequences. This plan may use annuities or other non-market-correlated products to improve your portfolio’s performance. By robustly managing market risk and stabilizing your exposure to volatility, you can avoid being blindsided by the difference in expected returns. You can also benefit from seeking a second opinion from an experienced retirement income planning. You cannot completely control or eliminate sequencing risk, but there is a possibility to limit your downside risks through diversification and other strategies.
In addition to diversifying your investments, you might want to think about working a few years longer, particularly if you have a chance to put more in a company-sponsored plan. Also, no rule says you can’t keep saving and investing, even after retiring. You can’t use a traditional IRA, but you can have a Roth IRA or brokerage accounts. The critical thing is to think about sequencing risk now and plan.