Sequence of returns is one of the biggest risks in retirement. Here’s how it can upset the trajectory of retirement.
What exactly is the “sequence of returns”? The phrase describes the yearly variation in an investment portfolio’s rate of return. But what kind of impact do these deviations from the average return have on a portfolio’s final value?
Let’s take a closer look at a few different investment scenarios posed by BlackRock that compare multiple portfolios and the impact of the sequence of returns based on an investor’s position in life. The first study focuses on how market volatility affects a portfolio while assets are accumulating, while the second looks at how market volatility affects a portfolio from which distributions are being taken.
The first study found that the sequence of returns appears manageable during accumulation. It depicts three investors who start portfolios with lump sums of $1 million, and each of the three portfolios averages a 7% annual return across 25 years.
In two of these scenarios, annual returns ranged from a hypothetical -7% to +22% while in the third, the return is simply 7% every year. In all three situations, each investor accumulates the same total of $5,434,372 after 25 years. This is because the average annual return is a hypothetical 7% in each of the three portfolios [1].
It’s important to remember that investing involves risk, and investment decisions should be based on your own goals, time horizon and risk tolerance. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost.
The BlackRock study assumes that the three hypothetical investors evaluated their financial ability to continue making purchases through periods of declining and rising prices.
When you shift from asset accumulation to asset distribution, the story can change. There is the risk that your distribution strategy could coincide with a period of declining prices, which may present a challenge.
The second model prepared by BlackRock compared three hypothetical portfolios starting with $1 million. All three portfolios took $60,000 in annual inflation-adjusted withdrawals [1].
One portfolio performed well in its early years, earning a 22% return in its first year and a 15% return in its second year. Though it suffered some losses in its later years, the portfolio actually increased in value to $1.1 million 35 years later.
The second portfolio had losses in its early years of -7% in the first year and -4% in its second year. The portfolio ran out of money before the 35-year mark.
The third maintained a constant 7% rate of return, and despite taking no losses over the course of the investor’s distribution phase, the portfolio dropped to around $400,000 by the 35-year mark, illustrating just how important it can be to achieve high rates of return in the final years leading up to retirement and the first few years once you’ve entered retirement.
Furthermore, it may be even more critical to avoid catastrophic losses leading up to retirement and in the initial years of retirement. Though all three portfolios averaged a 7% annual rate of return over the course of 35 years, the early losses suffered by the second portfolio had negative long-term effects on the portfolio’s performance.
If you are preparing to retire, having an understanding of the sequence of returns may help you ask important questions about your overall investment strategy.
To learn more about major retirement risks like sequence of returns, you can reach Choice Financial Services, Inc. in Oklahoma City by calling 405-843-5540 or by contacting us here: https://choicefinancial.com/contact/
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The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.
