Hello. My name is Chad Taylor, managing partner with MDT Financial Advisors, here in Houston, Texas. With retirement comes an important shift in a client's financial picture. Instead of accumulating wealth and saving money, an investor may begin withdrawing money on which to live. As clients enter this distribution phase of their financial plan, portfolios can be especially susceptible to an investment risk called sequence of returns risk.
Sequence of returns risk affect investors who are actively withdrawing money from their investment portfolio. It represents the possibility that their investments may produce low or negative returns soon after initiating withdrawals. Low returns coupled with simultaneous withdrawals can create a situation where there is not enough time to rebuild the portfolio value, even if positive returns occur later. In the two hypothetical scenarios discussed, Mary and John both retire with the million dollar portfolio and withdraw $50,000 annually. Their portfolios also produce the same annual returns but in reverse order.
Mary's portfolio returns 16.7% during the first year and negative 25.6% the last. While John's portfolios return negative 25.6% the first and 16.7% the last. Although their five-year return both averaged 6%, Mary ends up with more money in her portfolio value than John. The only difference is the order or sequence of the returns.
Scenario one, positive returns in the early years of retirement. In scenario one, Mary began her retirement with a million dollar equity and fixed-income investment portfolio and made $50,000 annual withdrawals over the course of five years. Mary retired during a strong market, and her portfolio experienced or produced three years of positive performance followed by two years of market losses. After five years, Mary's account value was $1,010,110, slightly higher than the amount she started with at retirement.
In scenario two, we have negative returns in the early years of retirement. Like Mary, John also began his retirement with the same million dollar equity and fixed-income portfolio and made $50,000 annual withdrawals over the course of five years. In this scenario, however, John retired in a down market. During the first two years of his retirement, John's investment portfolio experienced market losses, returning negative 25.6% for the first year and negative 1.5% the second. Although the market rebounded during the next three years, the first two years of negative returns combined with his annual monthly withdrawal eroded his account value to $875,625 after only five years.
When clients begin withdrawing money from an investment portfolio, the first few years of returns can greatly affect how long their savings will last. Although both Mary and John began with a million dollars in retirement savings and withdrew $250,000 during the first five years of their retirement and realized the same average returns over those five years, Mary ends up with $134,485 more in portfolio value than John. What caused their ending accounts to differ? The only difference between the two scenarios was the order or sequence of annual returns. The returns occurred in reverse order.
It is important to manage your exposure to sequence of returns risk. There are a number of ways to safeguard your retirement savings from sequence of returns risk. Number one, maintain diversified sources of income. Having various types of income for your retirement, such as guaranteed, stable, and growing, can help pursue the retirement you envision.
Number two, develop a dynamic spending strategy. Uncertainty is a fact of life. A truly realistic approach to retirement planning doesn't just allow for changes in your personal and financial circumstances. It takes them as a given.
Number three, build a cash reserve. A safety net will help you take care of yourself financially in retirement. Number four, create a retirement strategy. There's never been a better time to sit down and take control of your future than today.
Although no one can control how the markets will perform, clients can work with their financial advisor to evaluate their investment portfolio's exposure to this sequence of returns risk. Understanding their risk factors can help clients make adjustments along the way as life and the markets continue to change. If there's anything that we can do here at MDT Financial Advisors, please don't hesitate to contact us. Thank you, and have a good day.