What’s more important, the investment rate of return or the order in which the investment returns are realized? Ask any investor and no doubt the prevailing sentiment would be the rate of investment return. In fact, the sequence of investment returns may be just as, if not more, critical to your retirement assets once withdrawals begin. Most financial advisors wrestle with sequence of return risk when providing retirement planning advice. This is the single greatest retirement risk about which most investors are unaware.
For many investors, market volatility does not represent an investment risk, as long as you are invested for the “long run“. This is simply not true in the case of a retirement portfolio that is exposed to market volatility while cash withdrawals are being made. Retirement portfolios with cash outflows are exposed to a subset of “market risk”, called “sequence of return risk”. Given the average length of market cycles, investors are exposed to sequence return risk 5-7 years before their anticipated retirement date. Investors who experience successive years of negative rates of return early in retirement can experience a significant increase in the risk of the “spend down” of their retirement assets. It is far better to have the poor investment return years that occur later in retirement than earlier because of the lower life expectancy.
Retirement Projections Can Be Misleading
Retirement plan projections that rely upon long term expected rates of return on investments can result in unrealistic assumptions that lead to a false sense of economic security. These types of retirement planning projections typically rely upon long-term performance averages with assumed spending rates to determine the longevity of retirement assets to meet retirement income needs. Increasingly, however, financial planners use sophisticated computerized models which use Monte Carlo simulations to estimate the likelihood of meeting retirement income needs. These retirement planning techniques address the sequence of return risks through the analysis of hundreds of scenarios, each scenario with a different sequence of investment return performance to determine an anticipated “success rate” towards meeting a stated income goal. The success rate becomes the new metric used to determine the true risks investors face generating income from retirement assets.
Since market performance and inflation rates are variables that cannot be controlled, it is important that financial planners help clients become realistic and conservative when establishing a distribution rate for their retirement portfolio. Academic studies suggest that a “sustainable” withdrawal rate may be no more than 5% of the retirement portfolio’s value, adjusted regularly for inflation.
Retirement Assets are Exposed to Spend Down Risk
Where there are no cash outflows in an investment portfolio, there is no sequence of return risk. Investment returns, good and bad, have more impact at some points in your lifecycle than at others. Negative investment returns early in retirement can result in greater financial damage than later in life. Retirement planning strategies that do not explicitly address sequence of return risks before retirement withdrawals begin are truly exposed to the vagaries of the securities markets.
For investors who approach important lifestyle changes, such as retirement, an investment strategy which takes into consideration current economic and market conditions can allocate portfolio investments to help mitigate sequence of return risk. A financial advisor can help implement a tactical asset allocation strategy to generate retirement income.
