When planning for retirement, most people focus on accumulating enough wealth to last through their retirement years. However, an often-overlooked aspect that can significantly impact your financial security in retirement is the sequence of returns risk. Understanding this risk and how it can derail your retirement plans is crucial to ensuring a stable and secure financial future.
What is the “Sequence of Returns Risk”?
The sequence of returns risk refers to the potential negative impact of the order in which investment returns occur. While the average rate of return over a long period is important, the sequence in which those returns happen can drastically affect the longevity of your retirement savings. This risk is especially pronounced during early retirement years when you start withdrawing from your investment portfolio.
The Impact of Negative Returns Early in Retirement
Consider two retirees with identical portfolios and identical average returns over 25 years. The only difference is the order in which the returns occur. Retiree A experiences several years of negative returns at the beginning of retirement, while Retiree B experiences those same negative returns later. Retiree A's portfolio is likely to deplete much faster due to the early withdrawals during a market downturn, reducing the principal and limiting the compounding growth potential of their investments.
Example of Sequence of Returns Risk
Imagine two retirees, each with R10 million in their retirement portfolio, withdrawing R400,000 annually for living expenses.
Retiree A faces a 16% market decline in the first year of retirement. This initial loss, combined with the annual withdrawals, significantly diminishes the portfolio. By year 18, Retiree A could run out of money.
Retiree B faces the same 16% market decline, but it occurs in year 10. This delay allows Retiree B's portfolio to grow for ten years before experiencing the downturn. As a result, Retiree B still has R4 million left in year 18.
This example illustrates how negative returns early in retirement can be far more damaging than the same returns occurring later.
Mitigating Sequence of Returns Risk
While you cannot control market performance, there are strategies to mitigate the impact of sequence of returns risk on your retirement plans:
Build a Cash Reserve: Maintain a cash reserve or a low-risk investment to cover the first few years of retirement expenses. This buffer can help you avoid withdrawing from your investment portfolio during market downturns.
Adjust Withdrawal Rates: Be flexible with your withdrawal rates. In years when your portfolio experiences gains, you can withdraw more. In years when the market is down, consider withdrawing less to preserve your principal.
Diversify Your Investments: A diversified portfolio can help spread risk across different asset classes, reducing the impact of a downturn in any single market. This strategy can provide more stability and protect against significant losses.
Implement a Dynamic Withdrawal Strategy: Adjust your withdrawals based on portfolio performance rather than sticking to a fixed withdrawal rate. This approach can help sustain your retirement savings through varying market conditions.
Utilize Guaranteed Income Sources: Incorporate guaranteed income sources, such as annuities or pensions, into your retirement plan. These sources provide a stable income stream regardless of market performance, reducing reliance on withdrawals from your investment portfolio.
A South African Perspective
In South Africa, where market volatility and economic uncertainties are common and expected, managing the sequence of returns risk is particularly important. Here are some additional considerations for South African retirees:
Understand Local Market Dynamics: Stay informed about local economic conditions and how they might impact your investments. This awareness can help you make informed decisions about your portfolio.
Seek Professional Advice: Work with a financial advisor who understands the South African market and can help you implement strategies to manage the sequence of returns risk.
Plan for Inflation: South Africa has experienced varying inflation rates, which can erode purchasing power over time. Ensure your investment strategy accounts for inflation to maintain your standard of living in retirement.
Conclusion
The sequence of returns risk is a critical factor that can derail your retirement plans if not correctly managed. By understanding this risk and implementing strategies to mitigate its impact, you can protect your retirement savings and ensure financial stability throughout your retirement years. At Family Wealth Custodians, we are dedicated to helping you navigate these complexities and achieve a secure and comfortable retirement. Prioritize addressing the sequence of returns risk to safeguard your financial future.
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