There are many risks to be aware of, whether you’re approaching retirement or already retired.
Stock market risk, bond market risk, interest rate risk, and the largest one is longevity risk. Longevity risk is outliving your money. With all of the advances in technology and healthcare we are living longer than ever before.
In this article, since we are especially focused on the returns our clients, we want to make sure you’re aware of the sequence of returns risk.
According to Investopedia, the Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor. This can have a significant impact on a retiree who depends on the income from a lifetime of investing and is no longer contributing new capital that could offset losses. Sequence risk is also called sequence-of-returns risk.
Let me explain that another way. Sequence risk is the danger that the timing of withdrawals from a retirement account will damage the investor’s overall return. Account withdrawals during a bear market are more costly than the same withdrawals in a bull market. It’s the negative compounding of math on the downside that will have long-term effects to run out of money.
Clients tell me they like pictures to explain points so here is the first visual.
To illustrate the point, let’s say you start out with $100,000 invested in stocks. In scenario 1, you experience negative returns at the beginning of your investment horizon, whereas in scenario 2 we flip the sequence so that the negative returns are at the end of the horizon.
As you can see, the ending value is the same, with the average return in both scenarios being 6.05%.
However, as we enter retirement, we must account for distributions, effectively changing the math. Using the same returns, let’s include a real income distribution of $50,000/year, assuming 2% inflation, from a starting nest egg of $1,000,000.
The “average” return in both scenarios is the same, but with vastly different outcomes. If we experience the negative returns upfront (scenario 1) we run out of money, a devastating situation in retirement. However, flipping the sequence (scenario 2) grows our nest egg to $1.6 million.
Last year’s returns for the S&P 500 were down -20%, the technology Nasdaq was down -30%, and the average bond fund represented by the Bloomberg Aggregate Bond Index or “the Agg” which is a broad-based fixed-income and that index (ETF AGG) was down -13.02% according to Morningstar.
To say this was devastating is an understatement. Investors who are 50 years and above have to rethink their retirement goals. People who are already retired are especially affected by the Sequence of Returns Risk which we just discussed.
You have to ask yourself, who is managing your 401k, IRA, Roth’s and after-tax accounts? How did that Target Date fund perform in your 401k?
If you would like a second opinion on your investments or retirement plan you can reach us at info@commonfinancialsense.com
