Dealing With Sequence Risk
Sequence risk, sometimes known as sequence of returns risk, is the peril that might be faced by retirees when they start drawing down their savings for living expenses. If you happen to retire at the wrong time—just before a severe bear market—you might run short of money in a relatively short time.
Some financial advisors are especially concerned about sequence risk for retirees who are following a schedule of drawing down their savings. Such plans typically begin with a specific percentage withdrawal in year one of retirement, followed by inflation-based adjustments.
Example 1: Molly Larson retires in 2015 with $1 million in savings. Molly’s plan calls for her to withdraw $40,000 (4% of $1 million) for living expenses this year. If inflation in 2015 is 5%, Molly would increase her 2016 withdrawal by 5%, to $42,000. If inflation in 2016 is 3%, Molly would increase her 2017 withdrawal by 3%, from $42,000 to $43,260. And so on.
Research indicates that such a plan has a very high likelihood of avoiding portfolio depletion over a 30-year retirement, assuming historic investment returns and inflation levels. Some advisors suggest another initial withdrawal rate, often in the 3%–5% range. Regardless, this strategy increases retirement withdrawals and decreases savings over time.
Enter sequence risk
If a retiree’s portfolio earns 7% or 8% every year, it probably can pay out the projected cash flow for 30 years or longer. However, investment returns fluctuate, and the sequence of those returns can be vital.
Example 2: Assume the same facts as in example 1. Molly’s portfolio grows by 15% in 2015, from $1 million to $1.15 million. Her $40,000 withdrawal reduces the balance to $1.11 million. If inflation is 5% this year, and Molly withdraws $42,000 in 2016, as planned, her withdrawal rate ($42,000 withdrawal from a $1.11 million portfolio) is around 3.8%. Molly’s withdrawal schedule seems to be on track.
A down year, however, won’t be so welcome.
Example 3: Assume instead that Molly’s portfolio falls by 15% in 2015, to $850,000. Now Molly’s planned $42,000 withdrawal would be over 4.9% of her savings. The higher withdrawal rate increases the risk of running out of money in her portfolio.
Serious for seniors
Sequence risk may not be a major risk for younger investors because initial setbacks can be recovered by later gains. That may not be true for retirees in the distribution mode, especially if their plan calls for increasing withdrawals to keep pace with inflation.
Early portfolio losses mixed with larger distributions result in a smaller asset base, so that the subsequent recovery won’t be as powerful. The effect of sequence risk is especially potent during the first five years of retirement distributions.
How can recent retirees and people approaching retirement reduce their exposure to sequence risk? You can discuss the issue with your financial or investment advisor. Get suggestions and decide whether they’re likely to be effective.
In general terms, sequence risk may be addressed by reducing portfolio volatility. The less chance you face a large portfolio loss, the less chance of seeing your savings depleted rapidly. Reducing portfolio risk usually means more asset diversification and less exposure to stocks, but this approach may reduce upside potential.
Reduced portfolio risk might be combined with increased distribution flexibility. After a down year, you may decide to hold portfolio distributions steady, or even decrease them. In any case, you should be aware of sequence risk and start your retirement with a strategy that won’t expose your life’s savings to rapid depletion.