Yesterday, I wrote about why financial planning is so important. I included an actual case study of how a robust financial plan can help shape your investment strategy to give you a better chance of achieving your financial goals and preserving your financial independence across a variety of market environments. In that commentary I introduced the concept of “Sequence of Returns Risk.”
Sequence of Returns Risk is absolutely critical to understand especially for folks within 5 years of retirement or who have retired within the last 7-10 years.
What It Means
Wade Pfau summarizes Sequence of Returns Risk in a 2013 article titled You Can’t Control When You’re Born… Revisiting Sequence of Returns Risk by saying,
“Two investors may enjoy the same average return on the investments in their portfolio, but may still experience very different outcomes if they experience a different sequence for when these returns arrive.” [emphasis mine]
This is still probably a little abstract so he goes on to illustrate…
Take 151 hypothetical investors who all work for 30 years, earn the exact same amount of money and all save 15% of their income each year. They also all experience 7% average annual returns, but it’s not a constant 7% return. The returns vary from year to year with a standard deviation of 20% which then results in an average 7% annual return for each investor over the 30-year time horizon.
The ONLY difference for these 151 hypothetical investors is the time period in which they worked and saved. This means the SEQUENCE of returns is different for each investor.
Given the fact pattern above each investor plans on having about 10x their final year’s salary saved up at the end of their 30-year career.
But where do they actually end up?
Below is a bar chart illustrating the size of each investor’s hypothetical portfolio at the end of their 30-year career (i.e. at retirement). Each blue bar represents portfolio size as a multiple of the final salary.
The red line represents the expected outcome (10x final salary). The blue bars represent the “actual” outcome.
Instead of all 151 investors having 10x their salary saved at retirement there is a very large range of about 3x to 28x final salary. Yet every investor saved the exact same amount of money AND experienced a 7% average annual return.
Everyone did the “right” thing yet some of these investors fell far short of their plan through no fault of their own. Others far exceeded their plan through no skill of their own. The outcomes were purely a result of when each worker happened to be born.
In fact, the investor who retired just ten years after the investor with 28x final salary only had 8.7x final salary saved despite the fact that 20 years of their careers overlapped!
Mr Pfau further observes, “What’s more, the person retiring only one year later than the fellow with 27.7x only had 17x their salary. This despite the fact that 29 years of their 30-year careers overlapped with one another.”
“This is sequence of returns risk! People are more vulnerable to the returns experienced when their portfolios are larger because a given percentage change has a bigger impact on absolute wealth. A big portfolio drop at the end could possibly wipe out all of the portfolio gains from the first 25 years of one’s career.” [emphasis mine]
Hopefully this further clarifies why I stress the importance of bear market stress tests in financial plans…especially for clients who may be near retirement or recently retired.
So the question for you is, “Are you proactively managing this risk in your own portfolio or are you leaving your retirement up to fate?”