The risk we’re going to discuss in this issue is one you may never have heard of, but it’s one that threatens every senior. It’s called sequence of returns risk. To understand where this threat comes from, you have to think about one popular method of growing savings.
When you set your savings aside, you’ll generally invest it in something—stocks, bonds, mutual funds, or a combination of all of these products—in order for that money to hopefully grow. When it’s time to take a distribution, unless you have sufficient cash reserves in your portfolio, you’ll have to sell a portion of the holdings you have in order to free up the cash you need to take the distribution. Once you liquidate a portion of these holdings, that portion is no longer available to keep making gains for you.
For example, let’s say you have 100 shares of ABC Corp and its current value is $50 per share. If you need to take a $5,000 distribution, then you can sell all 100 shares. Once you do, you’ll be able to get your expected income—but if the value of ABC Corp climbs any more, you won’t be able to participate in those profits because you sold your holdings.
Sequence of returns risk enters the scene when you have to start selling your holdings early on in retirement and you do so when they have a low return—or no return at all.
The less your stocks are worth, the more you have to sell in order to get the cash you need for your distributions. If you have to liquidate giant portions of your holdings early on in your retirement because the market is down, or your portfolio simply isn’t performing, then you are significantly reducing your portfolio’s ability to grow and support you into the future.
Think about it this way: those 100 shares of ABC Corp we talked about earlier? Let’s say you didn’t sell them when they were at $50 per share but istead you were able to hold onto them until they reached $65 per share. Then you would only need to sell about 77 shares to get your $5,000 distribution and you would keep roughy 23 shares in your portfolio, still growing.
It’s impossible to time the market and ensure that you’re never a victim of sequence of returns risk. But you can focus on investing in some assets that give income guarantees that are not dependent on the market performance.
In the next volume of the THREATS TO POSTRETIREMENT INCOME series, we’re going to talk about how the ever-changing tax environment plays an important, and sometimes devastating, role in the state of your postretirement finances.