Sequence of returns risk explained

If you’re within a decade of retirement, the current stock market volatility may be a good reminder of a key risk that lies ahead for your nest egg.

While stocks tend to offer the best opportunity for long-term growth despite their ups and downs, a persisting market downturn heading into retirement can be problematic if you’ll need to tap those assets when prices are down. That can permanently reduce how long your portfolio will last, said certified financial planner Mike Casey, founder and president of AE Advisors in Alexandria, Virginia.

This happens “by forcing investors to sell depressed assets and reducing the capital base available for recovery,” Casey said.

This problem is known as “sequence of returns” risk, which essentially means that the order, or sequence, of your gains or losses over time matters when you liquidate your investments.

“The best way to handle sequence of returns risk is to put a plan in place before someone retires,” said CFP André Small, founder of A Small Investment in Houston. “I typically encourage clients to start planning for sequence risk at least three to five years before retirement.”

Since the Feb. 28 start of the war in Iran, the major stock indexes have zigzagged on a downward trajectory amid high oil prices, fears of inflation and uncertainty about when the conflict in the Middle East will end. Year to date through Thursday, the Standard & Poor’s 500 index — a broad measure of how U.S. companies are faring — was down about 4%. The Dow Jones Industrial Average closed down 3.1% for the year, and the tech-heavy Nasdaq Composite Index has dropped roughly 7%.

However, last year, the S&P jumped more than 17%, the Dow gained about 13% and the Nasdaq was up 19.8%. While it’s impossible to predict where the stock market will go from here, volatility is expected.

For long-term savers — those whose retirement is many years or decades away — the ups and downs of the stock market generally matter less because their portfolios have time to recover before being relied on for income. For those investors, “the sequence of returns risk … isn’t such a big deal,” said CFP Frank Maltais, a financial advisor for Fidelity Investments in Portland, Maine.

For new retirees, though, it can make a big difference, Maltais said.

“If you retire into a poor market, that can diminish your nest egg over time, especially if you don’t scale down your withdrawals during that declining market,” Maltais said. “On the other hand, if you have a strong market early in retirement, that can really put the wind at your back.”

For illustration, according to a recent report from Fidelity: If a retiree starts with a balance of $1 million and withdraws $50,000 each year, and there’s a sequence of positive returns early in retirement followed by a bear market later on, the portfolio will have a balance of more than $3 million after 30 years. On the other hand, if there are negative returns early in retirement, followed by a bull market, the portfolio would be depleted in 27 years.

He used the early 1970s as an example: If a 65-year-old retired around 1972, right ahead of them was the 1973-1974 bear market, when the S&P dropped 48%. “That was a time when you had really high inflation, we had an oil crisis and we had a lot of political instability,” Maltais said.

“Investors who had a balanced portfolio that had different asset classes — stocks, bonds, cash — and were drawing 4%, they might have seen that portfolio last,” he said.

But someone who had to withdraw more risked running out — and the higher the rate of withdrawal, the earlier the age that the portfolio would have been depleted, he said.

It’s also important to have a good handle on what your expenses in retirement will be, advisors say, as well as your sources of income — i.e., Social Security, pension, annuities, part-time work. This helps to determine how much of your portfolio you’ll need to use in any given year.

“Understanding spending needs is the most important item to begin mitigating this [sequencing] risk, rather than starting with portfolio allocation,” said CFP Matthew McKay, director of investments for Briaud Financial Advisors in College Station, Texas.

“The reason we start there is to understand, what level of cushion do we need to build into the [asset] allocation,” McKay said.

“Once we have that number, we build a base of income-oriented assets, meant to be used for those early years of spending, to ensure that we have time to see markets move and perhaps recover if there’s a decline, without needing to sell into weakness,” he said.

Maltais said that the rate of withdrawal can influence how much of a portfolio should be in stocks. For example, someone who has enough other sources of income may only expect to need 1% of their portfolio yearly. That investor may afford to be more aggressive in their investing, he said, compared with someone who expects to need 6%.

One way to plan against the risk is to have a solid emergency fund, Maltais said.

“Try to have one to two years of expenses in cash,” he said. “That way if there is an unexpected downturn, [retirees] don’t necessarily have to sell their portfolio down as much if an unexpected expense happens.”