Here’s the Skinny…
Risk Managed Accounts may subdue Sequence of Returns Risk (Part I)
For simplicity, I’m going to start this explanation with data published by BlackRock used to illustrate a basic understanding of sequence of returns risk.
Stated simply, during accumulation and/or savings years, sequence of returns has zero impact. Meaning, if you start with a lumpsum, the order of identical annual returns (positive or negative) has no bearing on the end result.
However, the opposite is true during the distribution and/or retirement income years. If you are making withdrawals and/or extracting income then the sequence of returns is crucial. In fact, it can make or break your retirement. Negative annual returns experienced early during one’s distribution years may spell disaster.
Assume the following:
Scenario 1: Accumulation or Savings Years
- Three investors made the same initial hypothetical investment of $1,000,000 at age 40 with no additions or withdrawals.
- All had an average annual return of 7% over 25 years. However, each experienced a different sequence of returns.
- At age 65, all had the same portfolio value, although they had experienced different valuations along the way.
Scenario 2: Withdrawal or Distribution Years
- Three investors made the same initial hypothetical investment of $1,000,000 upon retirement at age 65.
- All had an average annual return of 7% over 25 years, which followed the same sequences as during the savings phase example.
- All made withdrawals of $60,000 (6%), adjusted annually by 3% for inflation.
- At age 90, all had different portfolio values after the same annual withdrawals.
Please refer to disclosures at bottom of post.
As you can see in scenario 1, the changing order for the annual returns has no impact on the end result. All three investors finish with exactly the same end accumulation value.
On the other hand, scenario 2 illustrates why historically the generally accepted “safe” withdrawal rate has been considered 4%. However, in current times as we’ve experienced significantly lower interest rates, the dot-com bubble and bear market of the early 2000’s, plus the 2008-09 financial crisis, many now contend that a 4% withdrawal rate is no longer safe – and that withdrawal rates should be dialed back to 3% or lower.
You see, this is not an exact science, as it depends on so many investment variations and factors. In scenario 2 for example, a 6% withdrawal rate was assumed and Mr. White ran out of money, while Mr. Rush may be in trouble depending upon how much longer he lives and what his future annual returns may be, yet Mrs. Doe appears to be in good shape financially.
When such “acceptable” or “safe” withdrawal rates are researched and calculated they are done so assuming static traditional investment allocations. Therefore, they assume, for example, that one simply must withstand and absorb declines from significant market downturns – yet the entire purpose of risk management is to mitigate downturns! And if one can mitigate downturns, the impact on the research and income calculations is significant (more on that in Part II)
However, unfortunately, investors are generally taught that accumulating a certain sized nest egg will solve all their retirement woes. But obviously, that is not the case. It helps, don’t get me wrong, more is always better than less when accumulating toward retirement. But scenario 2 shows very clearly that the accumulation amount isn’t the only important factor.
Yet most investors think that’s all there is to worry about – “I just need to save until I hit my magic number.” Again, it’s not that simple. Crafting a retirement income plan requires more knowledge, more sophistication, and different tools then does simply saving and accumulating toward retirement.
That’s the Skinny,
Mike Walters, CEO
Source: BlackRock. This graphic looks at the effect the sequence of returns can have on your portfolio value over a long period of time. Other factors that may affect the longevity of assets include the investment mix, taxes and expenses related to investing. This is a hypothetical illustration. This illustration assumes a hypothetical initial portfolio balance of $1,000,000 with no additions or withdrawals and the hypothetical sequence of returns noted in the table. These figures are for illustrative purposes only and do not represent any particular investment, nor do they reflect any investment fees, expenses or taxes.
Source: BlackRock. This graphic looks at the effect the sequence of returns can have on your portfolio value over a long period of time. Other factors that may affect the longevity of assets include the investment mix, taxes, expenses related to investing and the number of years of retirement funding (life expectancy). This is a hypothetical illustration. This illustration assumes a hypothetical initial portfolio balance of $1,000,000, annual withdrawals of $60,000 adjusted annually by 3% for inflation and the hypothetical sequence of returns noted in the table. These figures are for illustrative purposes only and do not represent any particular investment, nor do they reflect any investment fees, expenses or taxes. When you are withdrawing money from a portfolio, your results can be affected by the sequence of returns even when average return remains the same, due to the compounding effect on the annual account balances and annual withdrawals.