Retirement is supposed to be a time of relaxation and enjoying the fruits of one's labour. However, retirees face several risks that can significantly impact their financial stability. One such risk is sequence of returns risk, also known as return sequencing. This risk refers to the impact of the order and timing of investment returns on an investor's portfolio. In this article, we will explore the sequence of returns risk and provide strategies for managing it.
What is Sequence of Returns Risk?
Sequence of returns risk is the risk that an investor will experience negative portfolio returns very late in their working lives and/or early in retirement. This risk is particularly significant for retirees because they have little time to make up for losses that are compounded by the simultaneous drawdown of income distributions.
For example, consider two investors who retire with the same portfolio, take the same withdrawals, and have the same average annual return of 4%. However, Investor A starts retirement with a period of negative returns, while Investor B experiences positive returns early on. Despite both investors having the same average return over time, their returns' timing can significantly impact their portfolios. Investor A is at a higher risk of running out of money during retirement than Investor B due to the sequence of returns.
Why is Sequence of Returns Risk Important?
Sequence of returns risk is a crucial risk factor for retirees because of its impact on the sustainability of their portfolio. A period of negative returns early in the investment timeline can significantly impact the overall performance of an investment portfolio, potentially reducing the number of funds available for future withdrawals. This can be incredibly challenging for retirees and others relying on their investment portfolio to provide a steady income stream. In addition, a period of negative returns early in the investment timeline can also increase the likelihood that an investor will need to sell securities at a loss, further reducing the value of their portfolio.
Factors Affecting Sequence of Returns Risk
Several factors can affect the sequence of returns risk, including market volatility, market downturns, and retirement timing. Market volatility refers to the degree of variation in the price of an asset over time. High market volatility can make it difficult for investors to predict the returns they will receive, potentially leading to sequence of returns risk. Market downturns, on the other hand, can significantly impact an investor's portfolio value, particularly if they occur early in retirement.
Retirement timing is another critical factor that can impact sequence of returns risk. Retiring during or before a market downturn can significantly impact the overall performance of an investment portfolio, potentially reducing the number of funds available for future withdrawals. It is essential for investors to be protected from a poor sequence of returns during the "fragile decade" before and after retirement.
Managing Sequence of Returns Risk
Fortunately, several strategies can help investors manage sequence of returns risk. These include diversifying your portfolio, investing in annuities, delaying withdrawals, considering a phased retirement approach, and working with a financial advisor.
Diversify Your Portfolio
Diversifying your portfolio is an effective strategy for managing sequence of returns risk. Investing in various assets can reduce the impact of any single investment on your portfolio. A diversified portfolio should reflect your preference for the trade-off between risk and return, along with your investment objectives, risk tolerance, cash flow constraint, and tax situation.
In constructing your portfolio, endeavor to achieve an appropriate level of diversification across and within asset classes. This generally means a fairly large allocation to growth-oriented assets, like publicly traded stocks, and a meaningful allocation to more stable, income-oriented assets, like investment grade bonds.
Consider Annuities
Annuities can provide a guaranteed stream of income, which can help protect against the impact of negative returns. Annuities are insurance products that pay out regular income payments to an individual in exchange for a lump sum payment or a series of payments. Depending on the type of annuity, payments may be guaranteed for a certain period or for the individual's lifetime.
The lifetime income streams provided by annuities can help retirees minimize waste in retirement and protect against longevity risk and sequence-of-returns risk. These lifetime income streams may be created with variable annuities and other annuities offering guaranteed lifetime withdrawal benefits (GLWB), or via immediate or deferred annuities.
Delay Withdrawals
Delaying withdrawals is another strategy for managing sequence of returns risk. By delaying withdrawals, investors can allow their portfolio to grow, potentially offsetting any losses they may have experienced due to a poor sequence of returns.
Consider a Phased Retirement Approach
A phased retirement approach can help manage the sequence of returns risk by gradually reducing your exposure to the stock market over time. This approach involves transitioning from a full-time position to part-time work over a period of time, allowing retirees to continue receiving income while also reducing their exposure to market volatility.
Work with a Financial Advisor
Working with a financial advisor can help you understand the sequence of returns risk and develop a strategy to manage it. A financial advisor can help you assess your risk tolerance, create a diversified portfolio, and ensure that your retirement plan takes into account sequence of returns risk.
Conclusion
Sequence of returns risk is a significant threat to retirees, particularly those depending on their portfolio to provide a steady income stream. Market volatility, market downturns, and retirement timing can all impact the sequence of returns risk. Fortunately, several strategies can help investors manage this risk, including diversifying your portfolio, investing in annuities, delaying withdrawals, considering a phased retirement approach, and working with a financial advisor. By taking these steps, retirees can help protect their portfolio against sequence of returns risk, ensuring a secure and comfortable retirement.
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