Sequence of Returns Risk comes into play as you transition from your accumulation years, to your preservation and distribution years. It simply refers to the order in which good and bad market returns occur.
Think about it – if you take yearly withdrawals from a portfolio that is appreciating each year at a rate higher than what you’re withdrawing, the withdrawal will have little effect on your remaining balance. However, if you take withdrawals from a portfolio that is depreciating in value, your remaining balance is reduced by both your withdrawal AND the losses you experience. This can be devastating to your portfolio – and thus to your long term retirement success.
Here’s a great example from John Hancock, using historical returns that illustrate how sequence of returns risk could impact two identical retirement portfolios.
In this example, Mr. Smith retired in 1969 with $100,000 and Ms. Jones retired in 1979 with the same amount. Both invested in the same mix of 60% stocks and 40% bonds, taking 5% per year initially, then increasing the percentage withdrawn each year to keep up with inflation.
Both Mr. Smith and Ms. Jones had only four years of negative returns during the course of their entire 30 year retirement, which is exceptionally good. However, Mr. Smith experienced lower returns during his earlier years of retirement, as well as elevated inflation rates. Ms. Jones, on the other hand, experienced higher rates of return during her earlier years of retirement.
Both investors had attractive average rates of return and neither one experienced dramatic market crashes in their portfolios. And, although Mr. Smith’s overall average rate of return was higher, the combination of lower returns and high inflation in his earlier years caused the exhaustion of his portfolio after just 15 years while Ms. Jones died some 30 years later with almost 6 times what she started with.
What was the only difference in these two scenarios? It was the date they were born, which dictated the date they retired, which dictated the timing of their returns. In other words, even if you achieve your targeted rate of return over the course of your retirement, it won’t ensure your success.
In order to help mitigate these potential issues, we use a combination of the bucket plan and the cash flow pyramid approaches to investment planning.
DISCLOSURE:
Data based on two 31-year periods ending on December 31, 1998 and 2008, respectively. Each portfolio assumes a first-year 5% withdrawal that was subsequently adjusted for actual inflation. Each portfolio also assumes a 60% stock/40%bond allocation, rebalanced annually. Stocks are represented by the S&P 500. The Standard & Poor?s 500 Index (S&P 500) is an unmanaged group of large company stocks. It is not possible to invest directly in an index. Bonds are represented by the annualized yields of long-term Treasuries (10+ years maturity). Inflation is represented by changes to the historical CPI. Past performance does not guarantee future results. This illustration does not account for any taxes or fees.
Source:http://www.jhrollover.com/gifl/sequence_of_returns.html