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‘Sequence of Return Risk’ Can Ruin Your Retirement

November 18, 2018

By Martin Krikorian

During our lifetime, investing is essentially divided into two phases. The accumulation phase, when we are working and saving money for retirement, and the distribution phase, when we begin withdrawing income from our savings during retirement.

When you are saving money for retirement, the order or sequence in which you achieve your returns doesn’t affect its ending value. Regardless of whether the annual returns on a $100,000 portfolio over a five-year period are minus-10 percent, minus-10 percent, 10 percent, 10 and 10 percent, or in reverse order; 10 percent, 10 percent, 10 percent, minus-10 percent, and minus-10 percent, the portfolio would have the same ending value of $107,811.

Managing money during retirement requires a different investment strategy than managing money for retirement.

One of the most common and significant mistakes individuals make when it comes to withdrawing income during retirement is relying on “average returns.” Many individuals in retirement assume that if their portfolio earns an average return of six percent, and they withdraw 6 percent of income in their first year of retirement and continue withdrawing the same dollar amount of income every year thereafter, that they will not lose any of their principle or risk running out of money. Nothing could be further from the truth on -- both counts. This false assumption is one of the biggest reasons why many retirees are at risk of prematurely depleting their savings.

The fact is that when you start withdrawing money during retirement, the order in which your portfolio earns its annual returns, can have a large negative impact on your portfolios performance. This is known as sequence risk. Numerous studies over the last twenty years have demonstrated that investment losses occurring during the early years of retirement have a greater negative impact on a portfolios value than losses suffered during the later years in retirement. The reason is that negative returns combined with income distributions during the first few years of retirement, means having less money to compound, thereby increasing the likelihood of reducing your principal and potentially prematurely depleting your retirement savings.

The accompanying chart demonstrates the significant negative impact that sequence risk can have. Two portfolios start with the same amount of money ($500,000), earn the same average return (6 percent ), and withdraw the same amount of income ($30,000) each year. After 10 years, the first portfolio with the poor returns of minus-15 percent during the first three years, was worth nearly half ($260,485) of its original starting value. The second portfolio simply reverses the order of the returns. And reversing the order of the returns creates two vastly different outcomes. As a result of earning the higher returns during the early years, and the poor returns of minus-15 percent in the later years of 8 through 10, the second portfolio ended up with nearly twice as much money ($516,715) as the first portfolio.

When it comes to retirement-income planning, it is essential to have an investment strategy in place to help manage sequence risk. Designing a portfolio that seeks to provide more consistent returns, and which preserves capital by managing downside risk (especially during the first five years of retirement), is critical to the long-term growth of your savings. (Article and chart can be viewed on our website at www.capitalwealthmngt.com .)

Martin Krikorian is president of Capital Wealth Management, a registered investment adviser providing “fee-only” investment management services located at 9 Billerica Road, Chelmsford. He is the author of the investment books, “10 Chapters to Having a Successful Investment Portfolio” and the “7 Steps to Becoming a Better Investor.”

Martin can be reached at 978-244-9254, www.capitalwealthmngt.com ; or via email at info@capitalwealthmngt.com .

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