According to the old adage, timing is everything. And that’s especially true when it comes to ensuring that your retirement savings last a lifetime. Most investors are well aware of retirement concerns such as longevity risk (the risk associated with longer life expectancies requiring greater retirement savings levels) and inflation risk (the risk that the cost of goods and services such as healthcare expenses will significantly outpace investment returns). But very few realize the importance that sequence of returns risk may have on their ability to enjoy a successful retirement.
Sequence of returns risk refers to the devastating impact that negative market performance during the first few years of your retirement can have on the amount of retirement income your portfolio will ultimately generate. In fact, the order in which your portfolio returns occur as you enter retirement and begin drawing income from your investments is often more critical than the average returns you’re making on your investments.
As you are accumulating wealth, it’s only the average (not the order) of your annual returns that matters. Take two identical $1 million portfolios that are allowed to grow without taking any distributions. Assume that they both post identical 5.2% average annual returns over the course of a decade, but that those returns occur in a reverse order: