The Hidden Risk of Retirement: How the Sequence of Returns Could Impact Your Income
As investors, we often focus on the average return of an investment. We look at historical performance, analyze risk, and create a diversified portfolio that we believe will generate the returns we need to meet our retirement income goals. But there’s a hidden risk that many investors, particularly those nearing retirement, may not be aware of: the sequence of returns risk.
The sequence of returns refers to the order in which returns are received. It may not seem like a big deal, but the order in which you experience returns can have a significant impact on the overall performance of your portfolio and your ability to meet your retirement income needs.
For example, imagine two investors who both retire with a $1 million portfolio and withdraw the same amount each year. Investor A experiences a market downturn early in retirement and experiences an average annual return of 5%. Investor B experiences a market downturn later in retirement and experiences an average annual return of 8%. Despite the higher average return, Investor A would have less money left at the end of 20 years of retirement than Investor B.
This is because the early losses in Investor A’s portfolio limit the time that the portfolio has to recover and also limit the amount of money available to generate income during retirement.
To mitigate sequence of returns risk, investors can consider implementing a strategy of dollar-cost averaging, where they invest a fixed amount of money at regular intervals regardless of market conditions. Additionally, investing in assets with a lower correlation, such as bonds, can help reduce the impact of market downturns on the portfolio. Another strategy is to use a retirement income plan that aims to provide a steady stream of income and allows retirees to have control over the withdraw rate which in turn reduces their vulnerability to market fluctuations.
It is important to keep in mind that sequence of returns risk is one of the many risks that investors face, and that no investment strategy can guarantee a profit or protect against loss. But, by being aware of this risk, investors can take steps to mitigate its impact on their retirement income.
Sources:
- Forbes, “How to Understand Sequence of Returns Risk” https://www.forbes.com/advisor/retirement/sequence-of-returns-risk/
- T. Rowe Price, “Sequence of Returns Risk and the Impact of Asset Allocation on Outcomes” https://www.troweprice.com/content/dam/retirement-plan-services/pdfs/insights/investment-insights/Sequence%20of%20Returns%20Risk%20Summary.PDF
As investors, we often focus on the average return of an investment. We look at historical performance, analyze risk, and create a diversified portfolio that we believe will generate the returns we need to meet our retirement income goals. But there’s a hidden risk that many investors, particularly those nearing retirement, may not be aware of: the sequence of returns risk.
The sequence of returns refers to the order in which returns are received. It may not seem like a big deal, but the order in which you experience returns can have a significant impact on the overall performance of your portfolio and your ability to meet your retirement income needs.
For example, imagine two investors who both retire with a $1 million portfolio and withdraw the same amount each year. Investor A experiences a market downturn early in retirement and experiences an average annual return of 5%. Investor B experiences a market downturn later in retirement and experiences an average annual return of 8%. Despite the higher average return, Investor A would have less money left at the end of 20 years of retirement than Investor B.
This is because the early losses in Investor A’s portfolio limit the time that the portfolio has to recover and also limit the amount of money available to generate income during retirement.
To mitigate sequence of returns risk, investors can consider implementing a strategy of dollar-cost averaging, where they invest a fixed amount of money at regular intervals regardless of market conditions. Additionally, investing in assets with a lower correlation, such as bonds, can help reduce the impact of market downturns on the portfolio. Another strategy is to use a retirement income plan that aims to provide a steady stream of income and allows retirees to have control over the withdraw rate which in turn reduces their vulnerability to market fluctuations.
It is important to keep in mind that sequence of returns risk is one of the many risks that investors face, and that no investment strategy can guarantee a profit or protect against loss. But, by being aware of this risk, investors can take steps to mitigate its impact on their retirement income.
Sources:
- Forbes, “How to Understand Sequence of Returns Risk” https://www.forbes.com/advisor/retirement/sequence-of-returns-risk/
- T. Rowe Price, “Sequence of Returns Risk and the Impact of Asset Allocation on Outcomes” https://www.troweprice.com/content/dam/retirement-plan-services/pdfs/insights/investment-insights/Sequence%20of%20Returns%20Risk%20Summary.PDF