Managing Sequence of Returns Risk

by: Richard A. Anderson

A retirement calculator is a great tool for most investors. It lets you input a number of variables such as current age, planned retirement age, annual salary, annual savings, current retirement savings balance, and expected annual return and the calculator computes your estimated accumulated retirement account balance at retirement. Some calculators will even translate that lump-sum balance into an annual withdrawal amount. This is a straight-forward way to see if you are on track to meet your retirement goals and compare what you have with what you will need. If you don’t like your results, you can play with the inputs to determine what changes you should make.

The problem with retirement calculators is two-fold. First, you can make unrealistic assumptions about future savings and future expected returns. You can essentially have the calculator spit out a number that doesn’t properly reflect your future situation. For example, you can input a future expected return of 15%, but is that really reasonable? Second, the calculators assume you consistently earn the expected annual return. So, if you say you expect to earn 6% annually over the next 25 years, the calculator assumes you earn 6% every year for 25 years. However, the markets don’t produce consistent returns year-over-year.

Let’s look at a few examples to see how the variability of year-to-year returns affects wealth.

Suppose we have two investors (Mr. Green and Mr. Red) who are both age 41, plan to retire in 25 years at age 65, have a starting retirement account balance of $100,000, and don’t plan to make any additional contributions to their retirement accounts. Their situations are identical except they experience their annual returns in an inverse order from each other. See the chart below that demonstrates their different paths.

02182019_Sequence of Returns 1.png

Despite their sequence of returns being inverse, both investors end up with the same ending amount.

Now, suppose we have two investors (Mr. Lucky and Mr. Unlucky) who are both age 41, plan to retire in 25 years at age 65, have a starting retirement account balance of $100,000, and plan to contribute $20,000 to their retirement account at the start of every year. Their situations are identical except they experience their annual returns in an inverse order from each other. See the chart below that demonstrates their different paths.

02182019_Sequence of Returns 2.png

Despite Mr. Lucky starting off with three straight years of negative returns, he actually ended up with a much larger balance at retirement than Mr. Unlucky, who ended with three straight negative years.

Why is this the case?

The power of compound interest. When Mr. Lucky had his three years of negative returns, he had a smaller balance. Therefore, the negative returns had less of an impact because he earned higher returns in the periods where he had a higher balance. The opposite is true for Mr. Unlucky. This is most evident in looking at the divergence starting at age 58, where Mr. Unlucky’s account is nearly twice as large as Mr. Lucky’s.

Now, suppose we have two investors (Mrs. Fortunate and Mrs. Unfortunate) who both retired at age 66 with retirement account balance of $1,000,000 and plan to withdraw $40,000 from their portfolio at the start of every year until their passing at age 90. Their situations are identical except they experience their annual returns in an inverse order from each other. See the chart below that demonstrates their different paths.

02182019_Sequence of Returns 3.png

Mrs. Fortunate experiences positive returns early in retirement, while Mrs. Unfortunate experiences negative returns early in retirement. At age 90, Mrs. Fortunate ends up with a much bigger balance than Mrs. Unfortunate.

Why is this the case?

Once again, the answer is compound interest. But it’s the opposite of the previous example with the two individuals making contributions to their retirement accounts. Mrs. Unfortunate had three straight years of negative returns while taking withdrawals, so her principal value was declining due to negative returns and withdrawals. Essentially, she had a lower account balance to benefit from compound interest. The opposite is true for Mrs. Fortunate, who had three straight years of positive returns, which helped her principal value stay positive despite taking withdrawals.

What can you do to manage sequence of returns risk?

The best thing is to have excellent timing. Start saving when stock and bond prices are low and expected to rise. Retire when stock and bond prices are high and expected to remain stable. Good luck, though, because this is completely out of your control and no one has a crystal ball to predict the future.

Therefore, it’s best to focus on what you can control.

Start saving early and often. It’s easier to reduce the amount you save later in life if you realize your nest egg is enough to support your desired retirement goals than it is to ramp up savings as you get closer to retirement because you haven’t saved enough.

For individuals approaching retirement age, start building a cash reserve of one to two years of expected spending. This will help to reduce the effects of poor portfolio returns as you enter retirement because you won’t need to sell assets at lower prices to withdraw for spending. You can spend from the cash reserve and replenish the cash reserve once your portfolio recovers.

At HIGHLAND, our financial planning software allows us to run many different projections when building out your financial plan. One of the many benefits of our financial planning software as opposed to a standard retirement calculator is the ability to assume return variability. We can run different scenarios based on retiring into a down market, if inflation is greater than expected, if returns are lower than expected, and many more situations. This helps us to build a plan that more accurately reflects the investment experience you are more likely to have.