Retirement withdrawals made during a market fall leave less money invested for a later recovery. Sequence of returns risk therefore depends on when poor returns occur in relation to the income you are taking from your investments. The amount you need to withdraw affects how much of your retirement capital remains invested. A retirement plan prepared with Blue Diamond Financial can account for this retirement income requirement without assuming that future market movements can be predicted.
Two retirees can start with $800,000, withdraw the same amount each year and receive the same investment returns over ten years, yet finish with different balances. The difference comes from the order of those returns. Under sequence of returns risk, a withdrawal made after investments have fallen removes a greater proportion of the portfolio. Our retirement planning at Blue Diamond Financial accounts for the income you need to take from your investments as well as the returns they earn.
Sequence of Returns Risk
Take an $800,000 portfolio that falls 15% to $680,000. Withdrawing $40,000 at that point leaves $640,000 invested. A later market recovery is earned on that $640,000 rather than the amount that would have remained if no withdrawal had been necessary.
The order of events has a direct effect on the capital left invested:
- A market fall reduces the value of the portfolio.
- A retirement withdrawal removes investments at those lower values.
- Those sold investments are no longer present when prices recover.
- Each subsequent withdrawal is taken from the capital remaining at that time.
ASFA modelling found that significant losses early in retirement shortened the life of a modelled retirement income stream by considerably more than a loss later in retirement. This is the practical problem behind retirement portfolio drawdown.
Retirement Income and Portfolio Recovery
The amount you need from your portfolio determines how much you must sell during a poor market. If $20,000 of your annual spending comes from other income, your investments have less to fund than they would if the entire amount had to come from the portfolio.
For sequence risk in retirement, the useful question is therefore specific: how much capital would you need to withdraw to pay for your lifestyle during several poor investment years? Retirement withdrawals during a market downturn affect the answer because every investment sold reduces the capital available for a recovery.
Sequencing Risk in the Retirement Plan
Holding additional defensive assets is not automatically the answer. Reducing growth assets may reduce some short-term volatility, while the lower growth exposure also affects the return expected from the portfolio over a long retirement. Our asset-allocation approach takes your age, goals, personal circumstances and risk profile into account instead of relying on forecasts of the next market rise or fall.
Your sequencing risk also depends on the amount you withdraw and the income available outside the portfolio. If discretionary spending can be reduced after a poor year, fewer investments need to be sold at depressed values.
Once withdrawals are being made, retirement investment risk cannot be measured from market volatility alone. The same fall has a different financial consequence when you need to sell $50,000 of investments than when your other income allows you to leave those investments untouched. Managing sequence risk in retirement therefore requires the retirement income calculation to sit alongside the investment strategy, without trying to forecast the order of future returns.
Discuss sequence of returns risk with Blue Diamond Financial for your retirement.
