Sequence of Returns: Why Timing Matters in Retirement Planning
Imagine you’ve reached the peak of a mountain after years of climbing. As you begin your descent , the weather starts to change unpredictably. Sometimes the weather is clear and sunny, making your descent smooth and safe. But sometimes, you hit patches of heavy rain or snow, which can make your path slippery and dangerous.
If you encounter bad weather early in your descent, it can make the journey much harder, increasing the risk of slipping or getting stuck at a higher altitude. On the other hand, if you start with good weather, you can make significant progress safely, giving you a better buffer for when the storms eventually hit.
When planning for retirement, most people focus on how much they need to save, the rate of return they might expect, and how much they’ll have once they retire. However, like descending a mountain after a climb, withdrawing money in retirement requires an entirely different set of skills and presents an entirely new set of perils to be aware of, especially sequence of returns. This concept can significantly impact how long your retirement nest egg lasts, especially when you start withdrawing money.
What is Sequence of Returns?
Simply put, sequence of returns risk refers to the order in which your investment returns occur. While the average return over time may look stable, the specific order of annual gains and losses can lead to vastly different outcomes. When you're accumulating wealth (adding to your savings), the sequence of returns doesn't matter as much. However, once you start withdrawing money, especially in retirement, it can make a huge difference.
An Example
Let's imagine two retirees, both with $500,000 saved and each planning to withdraw $25,000 per year. One retiree experiences negative market returns early on, while the other encounters positive returns first. Even if they both average the same rate of return over time, the retiree with early losses could run out of money years sooner than the one with early gains.
Why Timing Matters
The difference lies in how negative returns affect your balance while you’re withdrawing money. Early losses can diminish your savings, leaving less capital to grow when the market eventually rebounds. Meanwhile, positive returns early in retirement allow your money to grow, helping cushion against later losses.
How to Manage Sequence of Returns Risk
So, how can you protect your retirement savings from sequence of returns risk? Here are a few strategies that could help:
Diversify Your Portfolio: A well-balanced portfolio reduces the likelihood of experiencing large losses in any given year. (We actually discuss this in our previous post about asset allocation.)
Use a Withdrawal Strategy: Approaches like the 4% rule or flexible withdrawals can help you avoid pulling out too much money during down markets.
Consider Cash Reserves: Keeping a portion of your savings in cash or low-risk investments can provide a buffer when the market drops, allowing you to avoid selling investments at a loss.
Plan for Market Volatility: It’s important to anticipate that market ups and downs are inevitable. Having a strategy in place can help you weather the storm.
What Happens if You Don’t Plan for Sequence of Returns?
If you fail to account for sequence of returns risk, you may find yourself withdrawing from a shrinking balance, which can spiral into even bigger losses. This is especially critical in the first few years of retirement, where negative returns could irreversibly harm your long-term financial outlook. (There’s a lot more to retirement planning than tackling sequence of returns risk, of course.)
Next Steps
In summary, while we can’t predict market returns, we can control how we respond to them. With the right strategies in place, you can help minimize the impact of sequence of returns risk and ensure your retirement funds last as long as you do.
Providers & Families Wealth Management is a fee-only financial planning firm. Insurance services are offered separately through P&F Insurance Solutions. Guarantees provided by insurance policies are based on the claims-paying ability of the issuing insurance company. Past performance is not indicative of future results. Investing involves risk, including the potential loss of principal. This post is for informational purposes only and does not constitute financial, legal, or tax advice. For personalized recommendations, please consult a licensed professional.