Understand sequence of returns
While the sequence of investment returns matters as you save for retirement, it matters a great deal more after you retire.
During the long period you're saving for retirement, an average annual return is a helpful tool to see how your portfolio is doing. The sequence of those returns is less important during this phase because the returns tend to average out over the long accumulation period.
It's a different story in retirement when the sequence of returns can make a big difference in the amount of savings you have. Here's a hypothetical example1:
- Retirement age: 60 years old
- Investment at retirement: $1,000,000
- Annual distributions: $50,000, increased 3.5% annually to help offset inflation
- Compounded annual rate of return: 7%
Here are three possible outcomes resulting from different sequences of market returns — all equivalent to a 7% average rate of return.
With a fixed rate of return of 7% annually, the retirees run out of money at 97.
Rather than earning 7% every year, the investment earns 7% the first year, 27% the second year, -13% the third year and then repeats that sequence in clockwise order. The volatility means they run out of money six years earlier, at age 91.
In this example, the investment earns 7% in the first year, -13% in the second year and 27% in the third year — the negative return happens a little earlier. As a result, the investment runs out of money 11 years earlier than with the 7%/7%/7% sequence of returns — at age 86, even though the average rate of return is still 7%.
Here's what the three outcomes look like in ending-balance dollar amounts from the ages of 76 to 97.
|Annual Ending Balances for Three Different Sequences of Returns ($)|
1 This hypothetical example is for illustrative purposes only. It is not intended to project performance, reflect fees and charges associated with any specific investment or show the effect of taxes on distributions.
Talk to your financial advisor about strategies to help offset the potential negative effect of sequence of returns on your retirement savings.