Retirement stress test part 2 – sequence risk
Sequence risk becomes a big problem once you start withdrawing from your portfolio.
Nobody is talking about this retirement risk.
What’s the trickiest part of a successful retirement plan?
Of the many retirement risks – like inflation and longevity – perhaps the most challenging one to manage is Sequence of Return Risk (aka Sequence Risk)
What is it?
Simply put, sequence risk, is the danger of the timing of your withdrawals having a negative impact on the longevity of your assets. Put another way, selling investments to generate income during a down (bear) market is more costly than the same withdrawals in a up (bull) market because you need to sell more of something if the price has gone down to generate the same amount of required income.
When is it an Issue?
Sequence of returns risk emerges when you begin regular withdrawals from your investment portfolio to fund retirement expenses.
Why is it an Issue?
Your portfolio will most likely be at its peak value at the beginning of retirement as it is the culmination of your life savings. Your investments are therefore at their point of greatest vulnerability, since any loss will be felt on the entire nest egg.
Once withdrawals begin, the order of your returns from year to year (whether positive or negative) matter as much as your average return. Without the proper strategies place, an unkind market in early retirement, could significantly increase the risk of early asset depletion.
Let’s Illustrate
Jane and Jeremy are saving for retirement. They both start with a $1,000,000 portfolio and both experience the same compound rate of return of 5.32%.
Who do you think will have more money after 9 years?
Notice that Jeremy has the same sequence of returns, just in reverse order.
Result
Both Jane and Jeremy end up with the same value of $1,513,433.
This was an old favorite when I used to teach financial planning to municipal employees because it’s a trick question.
However, as stated earlier, sequence risk becomes a big problem once you start withdrawing from your portfolio.
Now let us assume the same conditions as above with one exception: Jane and Jeremy require retirement withdrawals of $75,000/year from their portfolio.
Result
Jeremy ends up with 35% less than Jane.
This example clearly illustrates the risk. After 9 years, Jeremy has a portfolio that is 35% less than Jane’s even though they:
Both started with $1,000,000,
Both experienced the same compound rate of return of 5.32%, and
Both withdrew $75,000 /yr for 9 years.
How Do You Protect Yourself from Sequence Risk?
It is crucial to establish a plan to protect yourself from sequence risk if you are retired or transitioning to retirement.
Without divulging our ‘secret sauce’, we encourage you to seek help from a professional to implement some of the following sequence risk reduction strategies:
Buffer asset strategies,
Safe withdrawal rates,
Avoiding portfolios that are too risky/volatile,
Creating a diversified portfolio income stream, and
Annuitizing some of your income.
Want to know more? Please give us a call (604) 733-8888 or (250) 752-5100 or send us an email.
This information has been prepared by Lorenzo Pederzani, CFA, CFP®, CIM® who is the Chief Executive Officer (CEO) and a Portfolio Manager for Westmount Wealth Management Inc. and an Insurance Advisor for Westmount Wealth Planning Inc. Westmount Wealth Management Inc. is registered as a Portfolio Manager in British Columbia, Alberta, and Ontario. Westmount Wealth Planning Inc. is a subsidiary of Westmount Wealth Management Inc.
Hypothetical and historical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown.
In fact, there are frequently sharp differences between hypothetical and historical performance results and the actual results subsequently achieved by any trading program.
One of the limitations of hypothetical and historical performance results is that they are generally presented with the benefit of hindsight. In addition, hypothetical and historical trading may not present the financial risks and returns for future trading.
For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect trading results.
There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect actual trading results.
The example of compounded rate of return and/or the mathematical table shown is used only to illustrate the effects of the compound growth rate and is not intended to reflect future values of the investment fund or asset allocation or returns on investment in the investment fund or from the use of the asset allocation.
