Have you ever heard of the eyebrow-raising concept that has been dubbed the “sequence of returns risk?” It sounds complex, but it really isn’t.
Sequence of returns risk has to do with the order in which your investment returns occur during the distribution phase of your investment portfolio. Essentially, sequence of returns risk can be summed up by saying that your earliest retirement years will define your later years. Still confused? How about this? Author Tony Robbins stated in his book, “MONEY Master the Game: 7 Simple Steps to Financial Freedom,” that if you suffer investment losses in your early years of retirement, which is entirely a matter of luck, your odds of making it the distance have fallen.
Yep, it is a fact: When one begins to take withdrawals from their portfolio, the timing of good and bad years is everything. In other words, will the stock and bond market be in an upward or downward cycle when it’s time to turn on your income spigot? According to Robbins, if someone retired in the mid-1990s, he could have been a “happy camper.” If he retired in the mid-2000s, he may have been a “homeless camper.” As you can see, deciding when to begin taking income from your portfolio is perhaps akin to a lottery or luck of the draw.
Perhaps Mr. Robbins’ simple example will allow you to get a better grasp on the issue in question. For instance, although the following two phrases, “John bit the dog” and “The dog bit John,” have the same four words, when arranged in a different sequence, they have an entirely different meaning! Please hang with me, as this stuff gets significantly more noteworthy. In fact, when I am finished with this dispatch, I suggest that you might utter something analogous to the iconic phrase from legendary John McEnroe, “You can’t be serious!”
Before moving forward, please understand that the sequence of returns risk only applies when there is cash flow out of your portfolio. I suggest the best way to understand sequence of returns risk is with an example. (This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield or investment, nor is it indicative of future results.)
John and Jane earn the same “average” annual return of returns during a 20-year period of 7 percent. Keep in mind that “average” is simply total return divided by the number of years. In this scenario, regardless of how the returns are distributed during the accumulation phase, the average return is 140 percent divided by 20 or 7 percent a year.
Okay, back to John and Jane. Both make annual withdrawals that start at $50,000 and increase 3 percent a year. However, the sequence of returns (performance) during the distribution phase for Jane is rising in the early years and declining in the latter years while John’s returns did essentially the opposite. If you don’t think timing is critical during the distribution phase, think again!
John never recovers from early losses and runs out of money by year 19. Yep, John has portfolio ruin and is old and broke while Jane has $1.7 million after 20 years! This, my friend, is what is known as sequence of returns risk. Two folks, same amount for retirement, same withdrawal strategy. One is old and broke — not a good combination — while the other has some serious Benjamins! The foregoing sentence is worth reading a second time, and a third and a fourth. It is worth reading aloud! As much as everyone is entitled to his/her own opinion, nobody is entitled to his/her own facts! Okay, deep breath. Or loud scream!