Investing in retirement is different than investing for retirement. One of the most important differences is that the impact of market volatility (the ups and downs of your investments) gets amplified once you switch from accumulation to decumulation (the process of withdrawing money from a portfolio). This risk is manifested in what is called the “sequence of returns risk.”
The sequence of returns risk is just as it sounds: the order in which you experience investment returns matter, and they especially matter in the early years of retirement. If you retire and have poor market returns early on it can be very difficult to ever recover. Two similar retirees, who retiree with the same amount of money, withdraw the same amount from their portfolio, live the same length of time, and achieve the same average return, can have vastly different experiences all due to the market environment they retire into. As with most domains in life, timing matters in retirement.
Lets look at an example (while extreme) that shows how sequence risk works.
Bob and Joe both have $100,000 saved for retirement. First, let’s imagine that they don’t need any money from their portfolio. Bob’s portfolio returns 100% in year 1, and loses 50% in year 2. So after 2 years he is back to his $100,000 portfolio. Joe’s return order is flipped. In year 1 he loses 50% and in year 2 he makes 100%. He too is back to his $100,000 balance after 2 years. Bob and Joe’s geometric return is the same, 0%.
But now let’s imagine that Bob and Joe both need to take a $50,000 withdrawal from their portfolio at the end of the first year. Bob’s portfolio grows from $100,000 to $200,000 and then he takes out $50,000, leaving him with $150,000 at the end of year 1. After the second year drop of 50% his portfolio is down to $75,000. On the other hand, Joe’s portfolio goes from $100,000 down to $50,000 due to the first year loss of 50%. He then takes out $50,000. Joe has no money left.
Again, this is an extreme example, but the point holds true no matter how much you withdraw. It is a mathematical reality for anybody withdrawing money from a volatile investment portfolio. When you retire, “average” market returns don’t tell us the full story.
Sequence of returns risk is also sometimes referred to as “reverse dollar cost averaging.” With regular dollar cost averaging you buy more shares when the markets go down. However, if the market goes down and you have to withdraw money, you will have to sell shares of your investments. Those shares then aren’t available to participate if the markets rebound.
So what is a retiree to do?
Sequence of returns risk is a function of volatility. So one step to minimize sequence risk is to decrease the overall volatility of your portfolio. You can achieve this by having less stock exposure and by making sure you are properly diversified. While sequence risk never disappears, it is most impactful in the first 10 years of retirement. Therefore early in retirement you need to be very mindful of how your portfolio is allocated.
Another way to manage sequence risk is by having some flexibility in your spending from year to year. Having some room in how much you need to withdraw from your portfolio gives you better chance of responding to poor market conditions. This flexibility is tied in large part to your other income sources, i.e. Social Security and pensions.
It pays to have a comprehensive plan in place before you retire that takes into account sequence risk. It is easy to model in excel a retirement plan assuming an average rate of return on investments. However, as hopefully the above illustrates, average returns aren’t the whole story. With financial planning software you can model sequence risk through the use of Monte Carlo simulations, which can simulate market volatility and its impact on your plan.
The final point that I would share is that managing your investments and finances in retirement should be an iterative process. You should revisit your plan periodically and make changes as needed.