According to the old adage, timing is everything. And that’s especially true when it comes to ensuring your retirement savings will last a lifetime. Most investors are well aware that today’s longer life expectancies mean they’ll need to save more for their retirement (‘longevity risk’). They know that the cost of goods and services—especially healthcare—could grow faster than their investment returns (‘inflation risk’). But very few realize just how important sequence of returns risk can be on their ability to enjoy a successful retirement.
What exactly is this risk?
We all instinctively know that strong market returns positively impact our wealth while poor returns negatively impact it. What sequence of returns risk refers to, however, is how important the market return during the first few years of your retirement will be to how much retirement income your portfolio will ultimately generate. In fact, the order in which your portfolio returns occur as you enter retirement and begin drawing income from your investments is often more critical than the average returns you’re making on your investments.
When you’re accumulating wealth, it’s only the average (not the order) of your annual returns that matters. Take two identical $1 million portfolios that are allowed to grow without taking any distributions. Assume that they both post identical 5.2% average annual returns over the course of a decade, but that those returns occur in a reverse order. Regardless of the sequence of returns, both portfolios end up being worth the same amount.
Yet markedly different results occur if you start taking annual 5% income distributions ($50,000/year) from those same two portfolios:
If market performance is strong early in retirement, despite a decade’s worth of withdrawals, the value of the portfolio manages to increase (Portfolio A). But just a few years of negative returns early on in retirement (Portfolio B) can dramatically hamper your portfolio’s ability to comfortably generate a lifetime’s worth of income.
While strong early returns help buoy and stretch the first portfolio, early negative returns create a snowballing effect, reducing the second portfolio’s value so much that the impact of later positive returns is lessened.
For most people nearing retirement, the past half dozen years have been good ones. You’ve been steadily and successfully building your wealth. So, why shift from offense to defense now? That’s probably the exact same question many who were nearing retirement a little over a decade ago were asking themselves—right before the 2008-2009 financial crisis happened. Today, many of those who retired in the teeth of that recession are still struggling due to the effect the resulting market correction had on their total wealth picture.
While no one can predict how the market will behave in the pivotal early years of their retirement, there are a number of more conservative investment strategies such as bond laddering, which when combined with effective asset allocation and carefully planned retirement spending rates, could significantly limit sequence of return risk.Disclosure 1 Your Truist Wealth advisor can work with you to evaluate, monitor and explore this and other strategies to help reduce potential sequence of returns risk.