Sequence of Returns Risk and Retirement

Good piece from the John Hancock website below that illustrates one of the biggest risks facing retirees – sequence of returns. Market performance varies year to year, and during the years you are building your nest egg this is not as much a concern since you can afford to wait out the cycles. However, this can be potentially devastating to retirees because they usually need to take money out of their accounts for income regardless of what the market is doing. In poor performing markets this acts as a double whammy to savings and can really throw the best laid retirement plans off track.

While guaranteed income in the form of an annuity is one way to combat sequence of returns risk, the associated costs and potential lack of liquidity from entering such a contract is a turnoff for some investors. An alternate option (which we believe should be built into any retirement plan) would be to take dynamic income withdrawals that allow you to adjust your income annually depending on how your portfolio did the prior year. Though there is less predictability in this method, the flexibility helps greatly improve the odds of making your money last throughout retirement.

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When you save and invest for retirement over many years, time is mostly on your side. The longer you save and the more you save, the more the compounding of returns can help to potentially increase your nest egg. The returns on stocks, bonds and cash vary from year-to-year, sometimes greatly. There can be long and short periods where returns are mostly positive or mostly negative. But over decades, these returns tend to average out, regardless of the order in which they appear. By saving regularly and staying invested through up and down markets during your working years, you shouldn't be overly concerned about the return you're getting right now.

The problem is that once you stop saving and start taking income from your retirement nest egg, the return your portfolio generates is now very important and can be the subject of great concern. If you take yearly 5% withdrawals from a portfolio that is appreciating each year at a rate higher than 5%, the withdrawal will have little effect on the remaining balance. Conversely, if you take 5% withdrawals from a portfolio that is depreciating in value the results might be devastating.

The experts call this "Sequence of Returns Risk" and it means that the order in which poor and good market returns occur after the accumulation stage ends and the distribution stage from your portfolio begins will have a significant impact on how long your retirement assets will last.

Here is a hypothetical example using historical returns that illustrates how sequence of returns risk could impact two identical retirement portfolios (See the table and chart below).

Mr. Smith retired in 1969 with $100,000 and Ms. Jones retired in 1979 with the same amount. Both invested in a mix of stocks and bonds, taking 5% per year initially, then increasing the percentage withdrawn each year to keep up with inflation. The ten year difference in their dates of retirement had a significant impact.

Mr. Smith experienced negative returns in four of the first ten years, as well as elevated inflation rates. Although his rate of return was higher, the combination of lower returns and high inflation caused the inflation adjusted exhaustion of his portfolio after just 15 years.

Ms. Jones on the other hand experienced negative returns in only two of the first ten years in retirement. Although she also experienced periods of higher inflation, timely positive market performance helped to grow her assets in the early years, and a strong bull market helped the assets continue to grow as she took income from the portfolio.

The main difference between these retirements was that Mr. Smith had the misfortune to retire at the wrong time.

Data based on two 31-year periods ending on December 31, 1998 and 2008, respectively. Each portfolio assumes a first-year 5% withdrawal that was subsequently adjusted for actual inflation. Each portfolio also assumes a 60% stock/40%bond allocation, rebalanced annually. Stocks are represented by the S&P 500. The Standard & Poor?s 500 Index (S&P 500) is an unmanaged group of large company stocks. It is not possible to invest directly in an index. Bonds are represented by the annualized yields of long-term Treasuries (10+ years maturity). Inflation is represented by changes to the historical CPI. Past performance does not guarantee future results. This illustration does not account for any taxes or fees.

Data based on two 31-year periods ending on December 31, 1998 and 2008, respectively. Each portfolio assumes a first-year 5% withdrawal that was subsequently adjusted for actual inflation. Each portfolio also assumes a 60% stock/40%bond allocation, rebalanced annually. Stocks are represented by the S&P 500. The Standard & Poor?s 500 Index (S&P 500) is an unmanaged group of large company stocks. It is not possible to invest directly in an index. Bonds are represented by the annualized yields of long-term Treasuries (10+ years maturity). Inflation is represented by changes to the historical CPI. Past performance does not guarantee future results. This illustration does not account for any taxes or fees.