![]() ![]() Sequence of returns risk widens the distribution of possible outcomes in retirement. These investment market-driven outcomes are unpredictable. The level of sustainable withdrawal rate from an investment portfolio is heavily influenced by what happens during this retirement red zone. Sequence of Returns Risk Creates A Wide Possibility of Outcomes ![]() The randomness of market returns matters a great deal during this retirement red zone because portfolios are large, and a given percentage change has a more significant impact on absolute wealth. This example illustrates the unfortunate power of sequence-of-returns risk. Retiree B ends up with almost $300,000, or 32%, less than Retiree A even though they had the same average return of 4.0% over the 10-year period. Retiree B starts his retirement at the beginning of a market downturn and suffers a series of negative market returns right away, followed by positive returns later. Retiree A starts his retirement when he is blessed with a series of positive market returns followed by a series of negative returns later. The only difference is in the ordering of the hypothetical annual returns. Both retirees start with $1,000,000 investment portfolios, take $50,000 annual withdrawals, and earn the same average annual return on their investment portfolios of 4.0%. Average returns can be misleading as it’s the sequence of the returns that really matter during this period of time, often referred to as the “retirement red zone.”Īs an example, assume you have two retirees, A and B. Sequence-of-returns risk is the risk that a series of poor returns can have an exponentially negative effect during this time frame. Sequence of returns risk is generally most acute during the ten years leading up to retirement and the ten years after retiring when the portfolio’s value is likely its largest. Value Is Driven By Sequence of Returns Risk Management Sequence of returns risk is arguably the greatest risk a retiree can face, especially for those funding a material portion of their retirement from an investment portfolio. The power of this strategy is derived from its management of sequence of returns risk. In exchange for being willing to reduce spending (or at least the amount you withdraw from your portfolio) during times of poor market returns, you can start with a higher initial withdrawal rate and even increase your level of spending if investment markets continue to perform well. Applying a dynamic, or rules-based, approach to portfolio withdrawals sounds complicated, but the concept is simple. In their “Alpha, Beta, and Now… Gamma” research paper, Morningstar found that applying a dynamic withdrawal strategy can add more value than all of the tax strategies combined. We have written in the past about the value of tax management strategies and mentioned that Vanguard, in their Advisor’s Alpha research paper, estimated the value of all tax management strategies combined to be as high as 1.85%. ![]()
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