Explaining Sequence of Returns Risk, it’s impact on new retirees, and actionable steps to take to help mitigate this risk.

“Sequence of Returns Risk” likely isn’t a commonly used term in your day-to-day life. So, I thought it’d be beneficial to dive into what this is, because it certainly is important to understand the effects it can have when planning your transition into retirement.

Sequence of Returns Risk put very matter of fact is the risk associated with the sequence, or the order, in which your investment returns occur. The order of your returns does not carry much risk at all when there are no contributions or withdrawals from the portfolio. For example, let’s assume you have a $1,000,000 investment that achieves the following returns:

Year-by-year Rate of Return

1st Year Performance: 10%

2nd Year Performance: 23%

3rd Year Performance: (-16%)

4th Year Performance: 9%

5th Year Performance: (-4%)

At the end of the 5th year, your $1,000,000 portfolio will have grown to $1,189,255. When assuming no contributions or withdrawals, you will end up with a $1,189,255 portfolio after the 5th year regardless of what order those annual returns are actually realized. Assume that same $1,000,000 earns those same five annual returns, but in this order:

1st Year Performance: (-16%)

2nd Year Performance: (-4%)

3rd Year Performance: 10%

4th Year Performance: 23%

5th Year Performance: 9%

After the 5th year, your $1,000,000 portfolio will be $1,189,255. Same as the above. So, as we see, there’s no “risk” in the order of returns. The “risk” aspect of this comes into effect when we start contributing to or withdrawing from the portfolio. For purposes of this blog, we’ll focus on the retiree side, but just make note that accumulators savings towards retirement experience this same Sequence of Returns Risk when it comes to their savings.

Let’s revert back to our example of having a $1,000,000 portfolio. But now let’s assume you need to withdraw from the portfolio. We’ll say you just retired, and you need $50,000 a year from your portfolio to sustain your lifestyle.

In the first sequence of returns we reviewed:

1st Year of Retirement: 10%

2nd Year of Retirement: 23%

3rd Year of Retirement: (-16%)

4th Year of Retirement: 9%

5th Year of Retirement: (-4%)

Taking $50,000 out at the beginning of each year, by the end of your 5th year in retirement your $1,000,000 portfolio would be $931,466.

Looking at the second sequence of returns. Again, same returns, just different order:

1st Year of Retirement: (-16%)

2nd Year of Retirement: (-4%)

3rd Year of Retirement: 10%

4th Year of Retirement: 23%

5th Year of Retirement: 9%

Taking $50,000 out at the beginning of each year, by the end of your 5th year in retirement your $1,000,000 portfolio would be $863,729.

That’s a difference of $67,737 less in Scenario 2. More than a year’s worth of withdrawals at this point. Even though you experienced the same performance and took out the same amount of money as Scenario 1. That’s the “risk” in the sequence of your returns. The difference in the two scenarios is that in the second set of returns, the negative returns occurred in the beginning of retirement. Having the negative returns up front lessened the positive impact the positive returns ultimately have. Receiving a 23% return on a $684,888 portfolio (where the portfolio would’ve been after taking the Year 4 withdrawal) grows your portfolio by $157,524. Whereas receiving that same 23% return on a $995,000 portfolio (where the portfolio would’ve been after the Year 2 withdrawal in scenario 1) grows your portfolio by $228,850.

Actionable steps to take:

If you’re approaching retirement, you may be wondering what steps you can take to help mitigate this risk. In financial planning, we often like to control the things we can control. Regarding retirement, we can control your asset allocation, the amount of risk within your portfolio, the diversification within your investments, the amount of cash reserves you keep outside of your investments, how much you draw from the portfolio (to an extent). You can’t control the year-over-year performance, but you can control how you respond to performance.

Two big steps you can take to help alleviate Sequence of Return Risk as you prepare for retirement:

1.)    Diversify your investments. Ensure you have funds that don’t all correlate with one another. Stocks react to certain economic news and company data differently than bonds. Within stocks, smaller companies may respond to certain economic environments differently than larger companies. U.S. companies may be less or more affected by global events than international companies. Short-term bonds are likely to be less affected by movements in interest rates compared to intermediate and long-term bonds. So on and so forth. By diversifying your portfolio and having multiple assets classes to pull from, you improve the flexibility of your distributions and can be more strategic about which assets you pull from at a certain time. For example, if it’s a year where stocks are performing poorly, but bonds are holding their value, that year you can decide to pull your distribution from the bond funds that are operating at a net positive and allow your stocks the time needed to recover.

2.)    Gradually build up your cash reserves leading into retirement. An appropriate cash reserves target varies for everyone and every household. A common rule of thumb during your accumulation years is 3 to 6 months of your expenses. This helps ensure you have enough liquid money available should you have an expensive event occur or experience a loss of income for a short period of time, while also making sure you don’t have “cash drag” on your portfolio in leaving too much money sitting safe and secure in cash and not potentially growing at a higher rate in other investments. As you get closer to retirement, however, your cash reserves target should increase. Again, everyone’s situation is different, but I like to have the retirees I work with build up around 2 years of withdrawals in cash reserves heading into retirement. This is further protection against a Sequence of Return scenario where you retire and immediately the stock and bond markets take a dive. This happened all too recently in 2022. 2022 was a rare year in which both stocks and bonds had dreadful performance. 2022’s performance by asset class:

 Ø  U.S. Stocks: (-19.53%)

Ø  International Stocks: (-16.01%)

Ø  U.S. Aggregate Bonds: (-13.16%)

Ø  International Bonds: (-12.92%)

If you retired at the end of 2021 and the money you needed for the coming years was entirely in stocks and bonds, you’d be left with no choice but to draw from funds that had just experienced the above awful performance. This is similar to the second set of sequences we reviewed and can lead to depleting your nest egg at a faster rate. The result of this may lead to you needing to reduce your spending targets in retirement, reducing the years your savings are projected to last, or reducing the inheritance you desire to leave. All things we’d like to avoid.

Building up cash reserves to cover a couple years of withdrawals provides you with additional flexibility should you happen to experience market performance such as 2022 early in retirement. Avoiding distributing from funds that have experienced significant loss and allowing them time to recover can add years onto the longevity of your portfolio.

Transitioning into retirement can feel daunting enough. Building up cash reserves is an often-overlooked part of retirement planning, but should you have the unfortunate timing of retiring right before a year or two of poor market performance, you’ll be happy you were prepared.

I hope this blog is helpful in describing what exactly Sequence of Return Risk is, and providing you with some steps to take in protection against that risk. Should you have any questions or should you need assistance preparing for your own retirement, please feel free to reach out.

Thank you,

Drew Schaffer, CFP®

Ellis Investment Partners, LLC (EIP) is an investment advisor in Berwyn, PA. EIP is registered with the Securities and Exchange Commission (SEC). Registration of an Investment Adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the commission. EIP only transacts business in states in which it is properly registered or is excluded from registration. A copy EIP’s current written disclosure brochure filed with the SEC which discusses among other things, EIP’s business practices, services and fees, is available through the SEC’s website at: www.adviserinfo.sec.gov The views expressed represent the opinion of Ellis Investment Partners, LLC (EIP) which are subject to change and are not intended as a forecast or guarantee of future results. Stated information is derived from proprietary and nonproprietary sources which have not been independently verified for accuracy or completeness. While EIP believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimate, projections, and other forward-looking statements are based on available information and management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions which may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Past performance of various investment strategies, sectors, vehicles and indices are not indicative of future results. There is no guarantee that the investment objective will be attained. Results may vary. There is no guarantee that risk can be managed successfully. Investments in securities involve risk, including the possibility for loss of principal. EIP does not provide tax or legal advice. You should seek counsel from your tax or legal adviser for your specific situation. Drew Schaffer is an independent Investment Advisor Representative of Ellis Investment Partners, LLC (EIP). Financial Planning and Investment Advisory Services are offered solely by EIP, a registered Investment Advisor, 920 Cassatt Road, 200 Berwyn Park, Suite 115, Berwyn, PA 19312, 484-320-6300.