When planning for retirement, some investors may focus on the average annual return. However, for retirees and those nearing retirement, another factor known as sequence-of-returns risk appears to be an important factor for consideration.
This concept relates to the specific order in which investment gains and losses occur, particularly once you begin withdrawing funds. This timing tends to influence the projected longevity of your savings.
How the Order of Returns Affects Capital
The timing of market fluctuations can influence the long-term sustainability of a portfolio. To illustrate this, consider two hypothetical investors who both hold identical $1 million portfolios. Over a 20-year period, both portfolios achieve the same average annual return, but the sequence of those returns differs:
- Scenario A: The investor experiences market declines in the initial years of retirement, followed by stronger performance later.
- Scenario B: The investor experiences positive returns in the initial years, followed by market volatility or declines later.
Even with identical long-term averages, the retiree in Scenario A faces a higher risk of depleting their capital prematurely. When an investor withdraws funds during a market downturn, they may be forced to sell assets at lower prices to meet their income needs. This reduces the portfolio’s total capital base, leaving fewer assets to benefit from an eventual market recovery.
In contrast, the positive early returns in Scenario B can provide a financial buffer. This cushion may allow the portfolio to better withstand subsequent volatility, as the base capital has had time to grow before significant market stress occurs.
Why Sequence Risk Emerges in Retirement
During the accumulation phase, regular contributions may help mitigate the impact of early losses. Once withdrawals begin, negative returns in the early years appear to have a long-term effect on portfolio sustainability.
Other factors such as interest rate fluctuations, inflation and global economic conditions may also contribute to the uncertainty of forward returns.
Additionally, as life expectancy increases, the period over which a portfolio must sustain withdrawal also extends, making early stage volatility a significant variable.
Risk Management for Self-Directed Investors
While sequence-of-returns risk cannot be eliminated, certain strategies attempt to assist in managing its impact.
Diversification and Asset Allocation
Maintaining a diversified mix of equities and fixed-income securities aims to moderate overall portfolio volatility.
Liquidity Reserves
Allocating a portion of the portfolio to low-volatility investments or cash equivalents tends to reduce the necessity of selling equity assets during market downturns.
Variable Withdrawal Rates
Adjusting withdrawal amounts in response to market performance may help preserve the underlying capital.
Investment Tools
Certain investment vehicles, such as actively managed ETFs, may incorporate risk-mitigation strategies. Investors should evaluate these tools based on their individual objectives and risk tolerance.
By understanding the order-of-returns effect and implementing measured strategies, investors attempt to navigate retirement with more confidence, even during periods of market uncertainty. For example, when planning withdrawals, self-directed investors should think carefully about account type and tax implications. The Tax Free Savings Account, Registered Retirement Savings Plan, and non-registered accounts all have different tax treatments and withdrawal rules. Planning with these distinctions in mind may help preserve capital, manage taxes, and maintain long-term portfolio sustainability.