Sequence of returns risk explained
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If you’re a decade away from retirement, current stock market volatility may be a good reminder of a significant risk looming over your nest egg.
While stocks, despite their ups and downs, tend to offer the best opportunity for long-term growth, a continued market downturn toward retirement can be problematic if you need to take advantage of these assets when prices drop. This can permanently reduce the lifespan of your portfolio, said certified financial planner Mike Casey, founder and president of AE Advisors in Alexandria, Virginia.
Casey said this happened by “forcing investors to sell stagnant assets and reducing the capital base available for recovery.”
This problem is known as “return sequence” risk; This essentially means that the order or sequence of your gains or losses over time when you cash out your investments matters.
“The best way to address return risk is to create a plan before someone retires,” said André Small, CFP, founder of A Small Investment in Houston. “I usually advise my clients to start planning for sequence risk at least three to five years before retirement.”
Volatility in markets is likely to continue in an environment of uncertainty
But last year the S&P was up more than 17%, the Dow was up nearly 13% and the Nasdaq was up 19.8%. While it’s impossible to predict where the stock market will go from here, volatility is expected.
For long-term savers (those who are years or decades away from retirement) ups and downs in the stock market generally matter less because their portfolios have time to recover before being relied upon for income. For these investors, “the order of return risk…doesn’t matter that much,” said Frank Maltais, CFP, a financial advisor at Fidelity Investments in Portland, Maine.
If you retire in a poor market, this can reduce your nest egg over time.
frank maltais
Financial advisor at Fidelity Investments
For new retirees, this can make a big difference, Maltais said.
“If you enter a weak market, that can reduce your nest egg over time, especially if you don’t reduce your withdrawals in that declining market,” Maltais said. he said. “On the other hand, if you have a strong market in early retirement, that can really put the wind at your back.”
For example, according to A new report from Fidelity: If a retiree starts with a $1 million balance and withdraws $50,000 each year and a series of positive returns occur early in retirement followed by a bear market, the portfolio’s balance will be more than $3 million after 30 years. On the other hand, if negative returns occur early in retirement and are followed by a bull market, the portfolio will be depleted within 27 years.
Your withdrawal rate matters
Maltais said the pullback rate is a key component of ranking risk.
He used the early 1970s as an example: If a 65-year-old retired around 1972, they immediately had the 1973-1974 bear market ahead of them. S&P fell 48%. “It was a period of really high inflation, we had the oil crisis, we had a lot of political instability,” Maltais said.
“Investors who have a balanced portfolio with different asset classes (stocks, bonds, cash) and are pulling 4% may have seen that portfolio last,” he said.
But someone forced to withdraw had a greater risk of depletion, and the higher the withdrawal rate, the sooner the portfolio would be depleted, he said.
Make sure you anticipate your retirement expenses
Advisers say it’s important to know what your income sources will be as well as your expenses in retirement; Social Security, retirement, annuities, part-time work. This helps you determine how much of your portfolio you need to use in any given year.
“Understanding spending needs is the most important element to begin mitigating this situation [sequencing] “Opt for risk rather than starting with portfolio allocation,” said Matthew McKay, CFP, chief investment officer at Briaud Financial Advisors in College Station, Texas.
“The reason we start here is to understand what level of cushioning we need to do. [asset] allocation,” McKay said.
“Once we have that number, we create a base of income-oriented assets to use in the initial spending years to see the markets move and perhaps make sure that if there is a downturn, we have time to recover without needing to sell on weakness,” he said.
The withdrawal rate can affect how much of the portfolio should be in stocks, Maltais said. For example, a person with sufficient other sources of income may only need 1% of their portfolio annually. This investor can afford to be more aggressive on their investments than someone who expects to need 6%, he said.
One way to plan against risk is to have a solid emergency fund, Maltais said.
“Try to cover your expenses for a year or two with cash,” he said. “So if an unexpected crisis occurs, [retirees] You don’t have to sell their portfolio at that low a price if an unexpected expense occurs.”
