What is Sequence Risk and How Could You Protect Yourself?
One of the major risks that you face in retirement that could drain your assets is called sequence risk. Many people are not fully aware about sequence risk and it can be devastating to your retirement if you don’t know how to protect yourself against it.
Basic Concept
Let’s first discuss some basic market risk concepts and then I will in detail explain how sequence risk is related but uniquely different than market risk?. Market risk and sequence risk are two totally different things so don’t confuse market risk with sequence risk. So, to first understand the impact of market losses, I give you an example that if someone has a hundred thousand dollars invested in the market and he experiences a 40% loss in the market, so he is now down to $60,000 but the next year there is a 40% rebound. So with this 40% rebound you again covered your losses and back to 100% invested money but still with 40% gain following a 40% loss your account would only be to 84,000 which means you are still down 16%. So, what if you had a 60% gain following a 40% loss? That sounds like you should be recovered right? no, your hundred thousand would only be 96,000 which means you are still down 4%. It would actually take a 67% gain just to get back to where you were following a 40% loss. So how long does it take to get a 60% return? Well, that takes time right it could probably take a decade or more. So, this is the first concept to understand. It is kind of the prerequisite to understanding how sequence work is understanding that concept of when the markets are down it is difficult for them to recover.
Side-by-Side Comparison
Now I am going to give you a very specific side-by-side comparison of sequence risks so that you can easily understand it, but there is one more important thing to understand that it has to do with the accumulation years prior to retirement and then the years in retirement. So, if you look at this image of a mountain that is what we call the accumulation years. So, this is while you’re working and saving for your retirement and then at the top of the mountain is when you would actually retire and when you look down the other side of the mountain these are your years in retirement we call them the distribution years.
Major Factors
And so the risk and many factors coming to play during your distribution years that you never had to deal with suring the accumulation years and sequence of returns is one of those things. Next, I am going to tell you how there is no sequence of returns risk during the accumulation years but there absolutely is during the distribution years.
Basically, sequence of returns has no impact during the accumulation years. Let’s assume that you started saving and investing at age 35 and at a retirement age of 65 these are the accumulation years in this example I’m using actual historical market returns, okay If you look here at the bottom we have an account balance of just under 500,000. Initially everything is identical with these two side-by-side scenarios but I’m going to shuffle the sequence of the returns which is to change the yearly order of the returns. They are the same returns just looking at the impact of if the returns would have come in a different order. Prior to retirement there is no sequence risk. But now let’s see how it looks in retirement. In this scenario everything is starting out the same. We are going to assume a 4% withdrawal rate for income and a 3% inflation rate in this simulation. And I’m using the same historical market returns because we don’t know which years the market will be up and which years the market will be down. By the age of 94 this account would have grown to 2.4 million. But now let’s see what happens with a different sequence of returns. I’m going to start shuffling through the various scenarios. Depending upon the sequence of the returns and this particular sequence is not very good and this one is even worse. So there is a possibility or a risk depending on the timing of the returns. That this account has completely run out prematurely. The income did not last as long as was anticipated or as long as was needed. In another scenario, two retirees are using the same withdrawal rate and also getting the same market returns and they are also using the same adjustment for inflation. The only difference in this example is the timing of when they retire. It is added here that they both received a different timing of the market, different sequence of the returns. Sequence of returns risk is a very significant thing. It’s something that you can’t predict, but it is something that you can protect against. By knowing how to use a proper strategy so that you can really almost eliminate sequence risk. But you got to have a strategy in place and you got to make sure you understand What sequence is.
Safe Withdrawal Rate And Dave Ramsey
Let’s discuss what is safe withdrawal rate. Dave Ramsey (Famous Financial Advisor) was in the news and in the media quite a bit lately because of some statements he said regarding a safe withdrawal rate. These examples were assuming a 4% withdrawal rate. And you can see that in some scenarios people will still run out of money and he was suggesting an 8% was all rate. He’s also assuming that the market returns an even 12% in all years which is never the case. Some years are going to be more some years are going to be last some years are going to be negative and so 8% is considered a very risky withdrawal rate.
Conclusion
In this article we have a detailed discussion about what is sequence risk and what is its impact on your retirement money and how could you properly plan to protect yourself and avoid sequence risk. Basically, sequence of returns is a risk that applies to retirement income strategy. It is the risk of negative market returns occurring late in your working years and/or early in retirement. At this stage of your investment life, market downturns can have a much more significant impact on your portfolio and your lifetime income strategy. In case you have any question regarding the subject issue, you can reach out to us any time and leave your comment and we will respond you as soon as possible. Thanks for taking interest in this article.
FAQs
Q. What is Sequence of returns risk?
A. sequence of returns is a risk that applies to retirement income strategy.
Q. Are Market risk and sequence risk are Same?
A. Market risk and sequence risk are two totally different things. If you closely read the above article, you will easy understand the difference between the two.
Q. When Do Risk Factors Come to Play?
A. the risk and many factors coming to play during your distribution years.