Sequence of returns – A significant risk that should not be ignored

Recent market volatility provides a vivid reminder that markets rarely go up or down steadily. And when markets trend down at a time when an investor is approaching or recently entered retirement, this can be cause for real concern. In fact, sequence of returns is one of the biggest potential risks to a retirement portfolio. Sequence of returns is the order in which investors experience returns.

In football, inside your opponent’s 20-yard line is referred to as the “red zone.” In retirement planning, the five years just prior to the retirement and the five years following retirement are considered to the retirement red zone. An investor just entering retirement who begins withdrawing money and experiences a period of negative returns could find that the timing of these negative returns leads to a significant reduction in their livelihood.

Two investors with the same long-term average return may end up with very different results depending on the order of those returns. Consider these two 20-year scenarios — one starting in 1989 and ending in 2008 and the second a simple reversal of the sequence. In each case, the average annual return is the same 8.43%. But the outcome for the two investors who commence retirement in each of those two years is dramatically different.

Let’s assume both investors:

  • Start with $1 million
  • Invest 100% in an S&P 500 Index Fund
  • Withdraw 5% or $50,000 in the first year
  • Increase annual withdrawal rate for inflation (assuming 3%)

In the first scenario showing 1989 to 2008, an investor experiences several good years, including a 31% gain in the first year. Over 20 years, the portfolio grows to $3.1 million.

In striking contrast, the investor in the second scenario with the reverse sequence of returns faces an immediate downdraft of 37% in the first year followed by significant declines in years seven, eight and nine. That portfolio shrinks to $235,000 after 20 years.

Again, the average annual return in BOTH scenarios is 8.43%. We should point out that this is an extreme example with 100% of the portfolios invested in stocks.



Post 2008, many investors approaching or in retirement faced this very scenario and had to make difficult choices. Some found that the only way to afford a comfortable retirement was to continue working and saving and postpone their retirement.

But risk in a portfolio doesn’t come just from stocks. Many investors with significant bond portfolios may face an unexpected shock as the Federal Reserve begins raising rates as promised in the coming months. When interest rates go up, the value of bonds and bond funds generally goes down.

We believe there are a number of ways to prevent an unfortunate sequence of returns from hurting your chances at a comfortable retirement:

  1. Assess your retirement readiness — At least five years before retirement, we encourage investors to do an assessment of their financial plan and retirement portfolio. This assessment should consider a variety of “worst case” scenarios and ask the tough questions about whether you have saved enough and, if the portfolio is significantly tilted toward stocks, whether it is time to consider paring back risk.
  2. Consider your guarantees — Many pilot investors will find comfort in knowing they will have some guaranteed income from their A Plan pension and their Social Security. Work with your advisor to assess optimum pension benefit options and Social Security claiming strategies. If additional guaranteed income is desired, commercial annuities may make sense. Work with your advisor to evaluate several products from highly rated insurance companies.
  3. Reduce exposure to the riskiest assets — For some, moving to a more conservative portfolio with less exposure to stocks as you near retirement can reduce the risk of a significant downturn. Reducing exposure to stocks should happen well in advance of retirement. This can be especially effective after a portfolio has experienced sizable gains in a strong market, allowing an investor to sell appreciated assets. A well-planned move to a diversified portfolio, including high-quality bond funds or an individual bond ladder, may make sense. While this move will reduce risk, it will also reduce the return potential for the portfolio. Keep in mind, with life expectancies expanding and people living longer in retirement, it is important to assess whether the lower returns will be adequate. Simply living off the income generated by conservative investments has been especially challenging in today’s low-yield environment.
  4. Continue to use dollar cost averaging to your advantage — Most investors approaching retirement are in their peak earning years and invest regularly, adding more shares during market downturns. At the same time, as retirees begin to shift toward the distribution phase of their portfolio, they experience essentially a reversal of the dollar cost-averaging effect. Here when you withdraw regular amounts, you will need to sell more shares in a down market to get the same dollar amount. It may make sense to avoid taking a large withdrawal from your portfolio during a market downturn. Consider taking less out or postponing a significant purchase early in your retirement if the market goes down.

For most investors, adequate planning and a well-diversified portfolio can reduce the potential risk due to sequence of returns. Maintaining some flexibility around the timing of withdrawals — and even the timing of retirement — can offset the potential impact of unexpected negative returns.

Robert L. Warner  is an executive vice president for Cleary Gull. With over 25 years of financial services experience, Warner specializes in helping clients achieve their retirement and estate planning goals with an emphasis on estate conservation and wealth transfer planning. In addition to his Cleary Gull executive responsibilities, he is actively involved in new business development and, as the managing director for the Private Client Group, focuses on his passion for client service.

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