Yes, I know; when it comes to investing, there is already a long list of risks to be aware of and avoid. But I must say, as a practicing financial planner I find it puzzling that this one does not get mentioned more often. Let me try to offer a brief but clear explanation.
Taking income from an account during a period of poor investment returns is a major risk for retirees, known as Sequence of Returns Risk. The income from the account magnifies the declining value of the portfolio, and can easily cause a retiree to run out of money.
EXAMPLE: Your account is worth $100,000 on January 1, and you withdraw $5,000 (5%) to supplement your income for your first year of retirement. By the end of the year, poor investment performance has caused your account to decline 8% in value. So, on December 31st, the end of your first year of non-working bliss, what is you account worth? About $87,000.
On January 1st of the new year, you take another $5,000 withdrawal to supplement your lifestyle for year two of retirement. And unfortunately, the financial markets are again struggling, and the value of your investments again decline by 8%. On December 31st, what is your account worth? About $75,040.
At this point you may be thinking; “I’ve only been retired for two years, and my account is already down almost 25% in value. Unless I go back to work, I’m going to be broke soon!”
This is an all-too-real scenario for people who retire and begin drawing income from invested savings during a time of poor investment performance. Anyone who retired in 2008, just at the onset of one the scariest financial crises our nation has ever seen, experienced Sequence of Returns Risk at it’s worst. Poor investment returns at the beginning of your retirement can have a very negative impact on your ability to stay retired, and can indeed cause you to run out of money.
Is there an upside example too? Of course! Using the same $100,000 account with a $5,000 annual distribution as above, we will now assume that the investment return is positive, and the account gains 8% each of the first two years, instead of declining. The result? At the end of year two, the account value has actually grown to about $106,240, net of the annual distributions.
Most people are not aware of the huge impact investment losses VS investment gains can have in the early stages of retirement.
What can be done, you ask? Sequence of Returns Risk can be reduced or even eliminated by carefully segmenting retirement assets to create income across multiple stages of retirement.
EXAMPLE: Divide your retirement assets into at least two accounts. Calculate the amount of income you need to withdraw each year, and allocate 5-10 years worth of withdrawals to an account with investments that have a low rate of volatility, or even to financial vehicles that provide a guaranteed stream of income. You are now able to draw the income you need without the impact of declining investment values.
You can then keep the rest of your funds in a separate account with investments geared toward growth potential. So, if this account declines in value during the early years of retirement, you are able to take your income from the other account, and not be forced to sell investments while they are down in value to get the funds you need for living expenses. The growth from this account can be captured from time-to-time and used to “re-load” the income-producing account.
Keep in mind that there are many ways to structure your investments to avoid the impact of Sequence of Returns Risk, and my intention here is to provide a brief example; a full discussion is beyond the scope of this article. I strongly encourage you to meet with a qualified financial professional to help you implement this or any other financial strategy.
Questions or comments? I can be reached at 972-930-5417, or at email@example.com.