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Sequence of Returns is a Sleeper Risk to Your Retirement

Sequence of Returns is a Sleeper Risk to Your Retirement

October 22, 2020

Here’s an interesting retirement risk that might take some thought to understand: ‘Sequence of Returns.’  The ‘Sequence of Returns Risk’ appears primarily for folks making regular withdrawals from a portfolio that includes stocks (equities). 

Scenarios 1 & 2.  The average return of both Scenarios is 6.0%.  Since there are no withdrawals, the ending balances of both Scenarios are identical. 

Now take a look at the next scenarios...

Scenarios 3 & 4.  These Scenarios are identical to Scenarios 1 & 2 except for the withdrawals.  Consider the difference between the ending balances in Scenarios 3 & 4.  While the average return is the same, the ending balances differ by $45 (5%). 

Example provided is for illustrative purposes only and specific situations may differ.

Over the course of 20-30+ years the ‘Sequence of Returns’ has huge implications for folks who plan to take withdrawals from their retirement portfolios. The amount of time before your portfolio is completely exhausted will depend upon the ‘Sequence of Returns’ earned by your portfolio, and the timing and amounts of your withdrawals.

One process to evaluate the risk presented by the ‘Sequence of Returns’ is to use Monte Carlo Simulation.  Monte Carlo Simulation takes historic investment returns and cycles through all the various sequences in different orders to determine the likelihood that a given portfolio composition and withdrawal rate will “succeed.”  Using this tool presents a difficult question:  What statistical confidence level do I want in my retirement plan?

Would you be satisfied with a retirement plan that works 4 out of 5 times, 80% of the time?  Would you prefer a retirement plan that works 90% of the time? The good news is that there are ways to invest money so that you do not have to choose from these lousy options.  I recommend that you discuss the ‘Sequence of Returns Risk,’ your investment risk profile, and your anticipated longevity with an Independent Financial Advisor.