Mary was 32 years old and wanted to help her retired parents find a wonderful and warm place to live. After her vast research, she discovered an exotic locale with an average annual temperature of 84 degrees. She knew her parents would be happy as warm weather was their greatest priority as they aged into retirement.
One night several months later, while reading by her living room fireplace, Mary received a call from her father who told her something astonishing about their new home: It was freezing! The temperature was a brisk, minus 10 degrees while the previous day had been 140 degrees in the hot desert sun. Mary had apparently fallen victim to the flawed logic of relying on the average without considering the variability that created that average.
This error of logic is best illustrated by the old saying, if my head is in the oven and my feet are in the freezer, on average, I’m comfortable. Although an average provides useful information, it is effectively meaningless as a decision-making tool unless considered in conjunction with other variables.
In retirement planning, the understanding of this additional information can mean the difference between running out of money only a few years down the road and living a long comfortable retirement while maintaining your ability to leave a substantial inheritance to your heirs at the end of your life. Specifically, it is the sequence of returns, as much as the average, that will have the greatest impact on your retirement nest egg.
The sequence of returns is the order of the returns you receive during your retirement while you are also distributing funds annually to cover your living expenses. In retirement, we may expect an average return of, say, 8%. However, if we invest in a diversified portfolio of stocks, bonds, real estate, etc., there will be few years (if any) when we actually receive an 8% return. Most years will be far from it; averaging our returns over a 30-year period to 8%. Some years may furnish an exciting +22% while others, a depressing -15%. It is precisely when we receive these returns, and in which order, that will determine a successful or unsuccessful retirement plan.
Notice an example illustrated by the chart below where 30 years of returns are given. Simply reversing the order of the returns, creates two vastly different outcomes. The portfolio with poor performance early in the 30-year period is depleted by year 17, while the portfolio with losses much later lasts for 30 years (or more) and increases in value. The average annual return is identical in both scenarios; however, the results are far from it.
The sequence of returns only becomes a factor when money is either added to or withdrawn from a portfolio. When contributing to a portfolio, you have probably heard the term “dollar cost averaging”. In retirement, dollar cost averaging is reversed as the investor must sell a certain dollar amount each month or year to support their lifestyle. Unfortunately, when investment prices are low, the retiree must sell more shares to receive the same amount of funds, thus aggressively cannibalizing a portfolio designed to last decades. The earlier in retirement that a poor market environment is experienced, the worse the overall results.
Sequence of returns is a hidden risk that can affect retirees without them even realizing it. There are remedies to this problem, such as reducing overall portfolio volatility, removing inflation increases during poor market years, and simply living off conservative investments such as cash and/or bonds during times of market turmoil. The point is to understand the risk and to know how to recognize and manage it if it does present itself early on in your retirement. If however, you are not comfortable managing this and the many other risks of retirement planning yourself, contact a good fee-only financial planner who specializes in retirement to make sure your nest egg lasts longer than you do.