The Importance of Understanding Sequence of Returns Risk
By Marjorie L. Rand, CPA, CFP®, RICP®
After years of saving and reviewing their account balances, many retirees are confident they’ve followed their plans properly. But a hidden danger lurks behind the numbers: sequence of returns risk.
Sequence of returns risk isn’t a stat that appears on your brokerage account. Nonetheless, losing sight of it can seriously affect your savings. Understanding how it works can help your hard-earned money last longer in retirement.
What Is Sequence of Returns Risk?
When you’re working or actively contributing to your retirement fund, market fluctuations may not have a long-term effect on your finances as long as the average return is solid and your portfolio grows in value.
After you retire and start taking distributions from your fund, however, sequence of returns risk can become an issue. It’s all about the order of your investment gains and losses after you retire. If the market faces a downturn in the initial months of your retirement, you might experience drastic losses that could drop your balance quickly.
An Example of Sequence of Returns Risk
To illustrate how the sequence of returns can affect your investments, let’s look at a hypothetical retiree. They have $500,000 in their retirement fund and withdraw $25,000 every year in retirement.
Now, consider the following two scenarios, each spanning 10 years:
- Scenario 1: The market enjoys positive gains in the early years of retirement but generates losses in later years.
- Scenario 2: The market starts out with steep losses and suboptimal returns but rebounds in later years.
In both scenarios, the average return over 10 years is the same: 3%.
Although they have the same average return over the course of a decade, the ending balance at year 10 in Scenario 1 is $413,805.40. Even with the gradual improvement in returns, the account balance after 10 years in Scenario 2 is $281,132.60—a stunning $132,672.80 less than Scenario 1.
Steps to Lessen the Impact of Sequence of Returns Risk
The most sensible way to reduce the impact of sequence of returns risk is to start taking withdrawals on your retirement when the market is going up. However, if you’ve already experienced a market loss due to sequence of returns risk, there are options for mitigating long-term risk.
Reserve Cash for Emergencies
Keep one or two years’ worth of living expenses in your cash reserves, separate from your retirement fund, to avoid withdrawing from your portfolio in a downturn. Stash your emergency fund in a money market fund or money market account..
Have Some Flexibility With Withdrawals
Scale back on your withdrawals and spending when the market is down. You can also pause adjustments for inflation if needed.
Formulate a Long-Term Plan for Success
At Rand Financial Planning, I focus on more than immediate returns. When clients work with me, I work to bring their needs and resources into balance for long-term, sustainable growth. In fact, it’s what I’m passionate about.
Schedule a 20-minute introductory call or reach out to me at 908-895-2406 or marge@randfinancialplanning.com to see if I’m the right fit to help you on your financial journey.
About Marge
Marjorie Rand is founder and financial advisor at Rand Financial Planning, a comprehensive, fee-only, fiduciary financial planning firm based in Flemington, New Jersey. Marge specializes in helping her clients plan for a secure retirement and navigate life’s many transitions through customized, tax-efficient retirement planning. She is passionate about empowering her clients to make the best financial decisions for their life and being by their side no matter what life throws at them. Marjorie spent many years as a CPA, specializing in estates, before founding Rand Financial Planning so she could be a go-to source for all her clients’ financial needs and help them avoid costly mistakes. She has a bachelor’s degree in accounting from Rutgers University and a Master of Science in Taxation from Fairleigh Dickinson University, along with the Retirement Income Certified Professional® (RICP®) and CERTIFIED FINANCIAL PLANNER® certifications. When she’s not working, Marge enjoys boating, horseback riding, traveling, and hiking with her husband and her dog, Rangeley. To learn more about Marjorie, connect with her on LinkedIn.