How sequence of returns can impact retirement savings, and what to do about it
Sequence of returns risk (or "sequential risk") is the potential impact of a significant market downturn during the early years of retirement, at a time when you need to draw an income from your investments.
The returns you earn during the first few years of retirement are particularly important. Above-average returns can allow savings to last longer, and to support a higher income stream. But above average losses can be hard to recover from. The reduced savings might not last as long as planned, potentially requiring you to live on a lower income.
Sequential risk emerges once you start drawing a regular income stream from your portfolio. Because the draw-down tends to reduce the asset base over time, investment returns early in retirement affect a larger pool of money. In effect, above average gains or losses early on are amplified in the years ahead.
A simple example illustrates how sequential risk can affect retirement savings. Imagine a hypothetical retiree who starts retirement with a portfolio value of $500,000. Over 30 years, they earn an average return of 5.4 per cent, and they withdraw an income of $21,000 per year (indexed for inflation of 2 per cent). Compare that scenario to two variations featuring an above-average gain or loss in the first year versus the last year of retirement.1
| Scenario A | Scenario B | Scenario C | |
|---|---|---|---|
| Starting balance | $500,000 | $500,000 | $500,000 |
| Annual withdrawal amount (indexed at 2%) | $21,000 | $21,000 | $21,000 |
| Return year 1 | -15.00 % | 5.40 % | 27.00 % |
| Return year 2 to 29 | 5.40 % | 5.40 % | 5.40 % |
| Return year 30 | 27.00 % | 5.40 % | -15.00 % |
| Value at year 30 | $104,148 | $548,881 | $835,723 |
| Average return for 30 years | 5.40 % | 5.40 % | 5.40 % |
Although all three scenarios produce an average return of 5.4%, you can see in scenarios A and C how dramatically an above average gain or loss early in retirement can affect the savings.
How to contain the risk
Fortunately, sequential risk can be contained if you follow a few fundamental investing guidelines:
- Avoid being overly aggressive with your retirement savings portfolio — ensure that your asset allocation strategy is appropriate for your risk profile. For example, a balanced portfolio with 50% equity and 50% fixed-income is likely to come through a market correction in better shape than an 80% equity portfolio.
- Avoid playing it too safe — too much emphasis on capital preservation can subject a portfolio to the "risk of no risk" where investment returns don't keep up with inflation, thereby gradually eroding the purchasing power of the savings.
- Be realistic about time horizons — Canadians are enjoying longer life spans. A typical retirement could last 20, 25 or even 30 years. That's why, especially early in retirement, it might make sense to maintain a balance of growth-oriented and income-oriented investments.
- Trust your plan — if you've decided that a particular asset allocation strategy is appropriate for your risk profile and long-term goals, then it's likely still appropriate after a short-term market correction. Long-term investors who react to short-term market movements by shifting assets often end up worse off than those who simply stay the course.
1 Source: Credential Qtrade Securities Inc. Monthly eNews, November 2014.