Sequence of Returns: Your Biggest Risk in Retirement

Dollar-cost averaging has always been a sound investment strategy. It consists of making systematic monthly contributions to a retirement account whereby a fixed dollar amount would purchase more shares when stock prices declined and fewer shares when they rose. Assuming the long-term trend for the stock market is up, as it has been for more than a hundred years, your average cost per share will be consistently lower than the current price over the long run. It’s a simple and sound strategy for the accumulation phase of a retirement plan.

But what about the distribution phase when it’s time to withdraw funds in retirement. Would a strategy of systematic monthly withdrawals be a sound retirement income strategy? Not likely. Although it would be a simple strategy, it would not be very sound.

Taking systematic withdrawals of equal dollar amounts for retirement income could be like dollar-cost averaging in reverse, whereby you would need to sell more shares when prices decline and sell fewer shares when prices rise.

While it may seem as if everything should balance out, the actual result is it would leave fewer shares that would be allowed to grow inside your portfolio. During a sustained market decline, especially in the early years of retirement, the rate of share depletion could make it difficult for your portfolio value to recover even as the market recovers.

For example, if you make systematic withdrawals of 5% of your portfolio value, and your portfolio value declines by 25%, it wouldn’t recover its value until the market rose by 45%. In a sustained market decline, that could take a while. In the meantime, you will be depleting your shares at a faster rate to maintain your 5% systematic withdrawals.

Understanding the Sequence of Returns Risk

When accumulating capital for retirement, the only thing that really matters is the average annual return earned during the accumulation phase. It doesn’t matter when the market rises or falls; the outcome will be an average annual return earned on your assets. However, when you start converting your assets into income, the sequence of market declines and gains very much matters.

Consider two retirement income portfolios that earn the same average annual return over a 30-year period. However, for Portfolio #1, the market declines in the first three years but has strong positive returns in the final five years. Portfolio #2 experiences positive returns in the first four years and negative returns in the last three years. The average rate of return for both portfolios is 6.5%. However, due to the impact of negative returns in the early years of Portfolio #1, its assets are depleted in 20 years.

The critical takeaway is that planning a retirement income strategy is much more complex than relying on simple assumptions or rules of thumb. Because it is impossible to project the sequence of stock market returns, your retirement income plan needs to include strategies that reduce your exposure to sequence of return risk.