What Is Sequence of Returns Risk and Why Does It Matter in Retirement?
When you're saving for retirement, market ups and downs are usually not a major concern. Over time, markets tend to recover, and your investments have years to grow. But once you retire and start relying on those investments for income, the timing of market returns becomes much more important.
What Is Sequence of Returns Risk?
Sequence of returns risk refers to the order in which investment gains and losses occur. While two investors may earn the same average return over time, the timing of those returns can lead to very different outcomes once withdrawals begin.
In simple terms, a market downturn early in retirement can have a much bigger impact than a downturn later on.
A Simple Example
Imagine two retirees each have $1,000,000 invested and both withdraw money to fund their retirement.
- Retiree A experiences strong market growth in the first few years and market declines later.
- Retiree B experiences market losses right after retiring and stronger returns later.
Even if both investors earn the same average return over their retirement, Retiree B may end up with significantly less money because withdrawals were being made while their portfolio was down.
This happens because money withdrawn during a market decline is no longer available to benefit from the eventual recovery.
Why Early Market Losses Matter
When you're retired, your portfolio faces two challenges at the same time:
- Market fluctuations.
- Ongoing withdrawals for living expenses.
If the market drops and you're still taking income from your investments, you're selling assets when they're worth less. This reduces the size of your portfolio and limits its ability to recover and grow in the future.
That's why the first few years of retirement are often considered some of the most important years for long-term retirement success.
Ways to Reduce Sequence of Returns Risk
While no one can predict what the markets will do, there are strategies that can help reduce the impact of poor market returns early in retirement.
Maintain a Diversified Portfolio
A mix of investments, including equities and fixed income, can help balance growth potential with stability. Equities help combat inflation and support long-term growth, while fixed income investments can help reduce portfolio volatility.
Keep a Cash Reserve
Many retirees choose to keep a portion of their retirement income needs in cash or guaranteed investments such as GICs.
Having cash available can provide flexibility during market downturns, allowing you to cover expenses without selling investments at depressed prices.
Consider Guaranteed Income Sources
Products such as annuities can provide predictable income for a specific period or for life, helping reduce the amount that must be withdrawn from investment portfolios during turbulent markets.
Have a Flexible Withdrawal Strategy
Rather than withdrawing the same amount every year regardless of market conditions, some retirees adjust their spending when markets are down. This can help preserve investments and improve the sustainability of retirement income.
The Bottom Line
When it comes to retirement investing, it's not just how much return you earn that matters. It's also when those returns happen.
A significant market decline in the early years of retirement can put pressure on a portfolio and increase the risk of running out of money later in life. Understanding sequence of returns risk and planning for it can help create a more reliable and sustainable retirement income strategy.
Working with a financial advisor can help ensure your retirement plan is designed to withstand market fluctuations while supporting your long-term goals.
Source: https://www.ig.ca/en/insights/what-is-sequence-of-returns-risk