Sequencing Risk and Its Challenges for Retirement Planning

If you look at any financial commentary, there is at least an article a day talking about investment risk. Investment risk, or the risk of losses due to market downs, is always something that we should be conscious of. But, for retirement investors, there is an even bigger risk than investment risk: sequencing risk.

This type of risk can be more dangerous than pure market risk because of the effects that it can have on your long-term retirement outlook. This can have a nasty impact especially if your money takes a hit in your early retirement years.

Sequencing risk looks at the order in which your portfolio returns occur. If you take losses early in your retirement, then it will impact your finances for the rest of your life. And you might well spend the rest of your retirement playing “catch-up” from those losses, especially if you were already drawing income from your portfolio and compounding the effects of those losses even further.

Sequencing risk can have strong effects on people’s financial wellness that can span years. So, it’s critical to have a strategy in place for this possibility, especially if you are in the retirement red zone (within 10 years before or after retirement).

Why Is Sequencing Risk a Greater Threat?

Dr. Wade Pfau is one of the leading researchers in retirement planning, income strategies, and sequencing risk. He noted the greater weight of sequencing risk versus investment risk in an article he wrote in an article appearing in Advisor Perspectives:

“Retirees face market risk, which concerns how market volatility causes average investment returns to vary over time. Sequence of returns risk adds to the uncertainty related to overall investment returns. The financial market returns experienced near one’s retirement date matter a great deal more than most people realize.”

“Even with the same average returns over a long period of time, retiring at the start of a bear market is very dangerous; wealth can be depleted quite rapidly as withdrawals are made from a diminishing portfolio and little may be left to benefit from a subsequent market recovery.”

He continued:

“Sequence of returns risk relates to the heightened vulnerability individuals face regarding the realized investment portfolio returns in the years around their retirement date. Though this risk is related to general investment risk and market volatility, it differs from general investment risk.”

“The average market return over a 30-year period could be quite generous. But if negative returns are experienced when someone has just started to spend from their portfolio, it creates a subsequent hurdle that cannot be overcome even if the market offers higher returns later in retirement.”

How Could Sequencing Risk Affect Your Retirement?

Even if your portfolio has large gains in later retirement years, the effects of early losses and a drawdown on a portfolio for retirement income can still linger.

Worse, they can stick to the point of the retiree having to downsize their lifestyle, go back to work, or be permanently stuck in employment. What’s more, that is assuming their health stays up to snuff.

Keeping the Effects of Sequencing Risk at Bay

How can the dangers of sequencing risk be countered? By combining modern strategies outlined by Dr. Wade Pfau: harnessing the powers of U.S. equity markets and the predictability as well as safety of income streams from annuities in a comprehensive retirement strategy.

Even if the market has a big swing down, fixed annuities will keep your money intact and keep paying you monthly income like clockwork. Insurance companies structure the risk they carry in unique ways so you, the annuity owner, have a higher degree of income certainty in your retirement.

How Does This Work?

Dr. Wade Pfau explains this by noting the differences between a defined-benefit pension plan and a defined-contribution plan like a 401(k) account. Whereas the 401(k) plan will produce an income stream that can change depending on how its assets perform in the market, pensions work quite differently.

The pension manager pools two types of risk that individual retirement savers can’t manage as well on their own. The first is longevity risk, where people are living longer thanks to advancements in medicine and technology.

Since pension plans pool risk across a wide stratum of investors, the pension manager can make certain assumptions about each person’s life expectancy. The manager can then structure monthly pension payments to each person based on these mortality assumptions. Those who die early will help subsidize the monthly payments to those who live longer.

Because of the strongly-pooled risk management, the second risk that a pension plan helps guard against is sequencing risk. While it would be hard for individual investors to recover against ill-gotten losses early in retirement, it’s much easier to absorb the effects of such risk when it’s pooled across many people.

Some investors will have good investing sequences that allow for more spending and more income certainty. Others won’t have as good of fortunes with the returns sequencing they earn.

But by sharing this market risk across many investors, the pension manager is able to “give the same average benefit for the same contributions” to everyone, as Dr. Pfau writes.

Why Annuities Are a Must in Managing Risk

Annuity companies handle this risk in the same way. And the way they invest the money they take in from fixed annuity premiums is also very conservative.

The bulk of the premiums (think more than 90 cents of every dollar) are put into low-risk, low-volatility assets like Treasury securities and investment-grade corporate bonds.

Hence, when they are held to maturity, these types of assets have more predictable and stable patterns of return than other equity-based assets. In contrast, those equity-based assets have fast-changing values that are determined by stock buyers and sellers.

Fixed indexed annuities also provide several other benefits, such as guaranteed lifetime income, tax-deferral, and exemption from probate. It should be noted that other types of annuities come with these benefits as well.

However, unlike other kinds of annuities, fixed indexed annuities lock in the interest that they earn during a given crediting period so that those interest earnings can’t be lost again.

Fixed indexed annuities are ultimately designed to provide higher growth than traditional fixed annuities.

Build Your Own Strategy Against Sequencing Risk

By incorporating a fixed annuity or indexed annuity into your portfolio, you can help establish a guard against sequencing risk and bring more peace of mind about your retirement strategy.

Ask your advisor about how they can help you find an annuity that makes sense for you and your plan. An independent advisor or agent can comb through multiple options and assist you in locating a solution that really fits your goals and situation well.

What if you need a financial professional to help you walk through your overall retirement “what-ifs” and find answers for your personal situation? No sweat. Many experienced and independent financial professionals are available at SafeMoney.com to assist you.

Use our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your situation and explore a working relationship. Should you need a personal referral, feel free to call us at 877.476.9723.