Making Your Money Last

Retirees Can't Afford to Underestimate Sequence of Return Risk

If the market tanks in the early years of your retirement, you could be in big trouble ... unless you're prepared.

Sequence of return risk, in my opinion, may be the biggest risk retirees face.

So, what is sequence of returns? It's the order in which you get the returns that your investments receive. Why is this so important? Before retirement, it doesn't matter what order your returns come in. The end result is the exact same number. But look at what happens when I take withdrawals from the accounts in the example below:

YearFund A returnsFund B returns
1(-30%)25%
25%12%
312%5%
425%(-30%)

Assuming I started with $1 million in each fund and a withdrawal of $60,000 per year, at the end of four years this is what my accounts would look like.

Fund AFund B
$720,000$831,768

The accounts both earned the exact same rates of return, and yet there is a $111,768 difference between them in only four years! Imagine going out 10 or 20 years.

You can see why I feel sequence of returns risk is one of the most important risks you face, and nobody even talks about it. I don't care nearly as much what return you get on your money in retirement; I care about the way you get it. A portfolio with a lower return can clearly leave you with more money if it is structured properly. This is the heart of income planning for retirees.

What You DON’T Want to Do

To put it simply, you do not want to lose money in your early retirement years. Losing money in the beginning of your retirement, when you are withdrawing money from your retirement plans, has the opposite effect of compound interest. Every withdrawal is compounded by the fact that the market is going down, causing you to spend down your retirement savings faster.

The reason advisers tell you to be more conservative in retirement is because you can't afford to lose money in the early years of retirement, or you might run out of money. In reality, however, this might be bad advice. Being very conservative when interest rates were 11% or when retirees lived to age 70 worked. Today, interest rates are not high enough to sustain most retirees, and many of them are living 30+ years in retirement.

An Easy Way to Avoid this Critical Risk

So, what is the solution? You need to mitigate sequence of return risk.

So how do we mitigate sequence of returns risk? One of the easiest ways is to remove money that you intend on spending in the first few years of retirement out of the stock market. If you don’t withdraw funds invested in the stock market when the market is down, then you avoid the negative compound interest effect in a declining market.

For those who are already retired, I like to keep five years or more of income safe from market declines. If you are still working, the number of years you plan on working until you retire can count toward the five years, since you may not start withdrawing until you actually retire. So, for example, if you are retiring in three years, then you need two years of retirement income out of the market.

For more conservative clients, you can keep up to 10 years of income protected. I wouldn’t suggest going beyond 10 years, though, because you want markets to help your portfolio over the long term. Keeping too much money out hinders the ability of the markets to help you.

If you can minimize the impact of early down-market years, you may greatly improve your chances of not outliving your savings. You may possibly even withdraw a larger percentage of your assets each year than what would normally be recommended. If it is done properly, you should also be able to increase your income with inflation.

Increasing retirement account withdrawal amounts, increasing withdrawals with inflation, and ensuring that your savings last as long as you do are the ultimate goals of retirement income planning.

Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax adviser with regard to your individual situation.

About the Author

T. Eric Reich, CIMA®, CFP®, CLU®, ChFC®

President and Founder, Reich Asset Management, LLC

T. Eric Reich, President of Reich Asset Management, LLC, is a Certified Financial Planner™ professional, holds his Certified Investment Management Analyst certification, and holds Chartered Life Underwriter® and Chartered Financial Consultant® designations.

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