& Sequence of Returns Risk
The recent market volatility has many Feds wondering if the longest bull-market in US history is finally beginning to falter. Many folks saving for retirement have seen most of their growth come from the market over the last 9 years due to the combination of low interest rate environment and strong economy that followed the financial crisis of ‘08. If the bull were to be ending, as all bull markets eventually do, it leaves those nearing and entering retirement in a particularly precarious position due to “Sequence of Returns Risk”.
This is the risk that you begin relying on your investments to provide income (a la someone entering retirement) during a negative sequence of market returns (aka bear market/recession). Suffering market losses is bad enough but compounding those losses with the withdrawals necessary to meet your income needs can create a retirement crisis.
While we may have some semblance of control over when we retire, we have no control over what the market does in the first few years immediately following our retirement.
To really help you grasp the significance of “Sequence of Returns Risk” we are going to break it down into three separate ‘bite-size’ concepts.
First is that there is a difference between the “Average Return” and the “Real Return” (or CAGR). The “average return” is what you most commonly see used to represent the historical performance of an investment. Your “real return” reflects the actual change in the value of your account. What is surprising to people is how dramatically different the two can be.
Are you sitting down? You might want to be for this hypothetical example…
Imagine this… you get a statement showing that the $100 you invested had AVERAGED 11% growth over the last 3 years. With that sort of average return, we would certainly expect our actual account balance to have grown significantly as well, right? But when you flip the statement over, the balance still only shows only the $100 you started with! How is it mathematically even possible to have a REAL RETURN of 0% when the average return showed 11%?!
Average Return Calculation:
Year 1 Return: -50%
Year 2 Return: +50%
Year 3 Return: 33%
3 Year average return = 11%
“Real Return” w/ Starting $100
-50% = $50
+33% = $100
3 Year Real Return (CAGR) = 0%
Obviously, this is an extreme scenario but it is simply meant to exemplify the difference between the “averages” you hear thrown about at the water cooler and the actual experience of your TSP account.
Now, the second concept is that, mathematically speaking, financial losses hurt more than financial gains help. Now you may be thinking DUH! Actually, behavioral finance has shown this concept holds true emotionally for the vast majority of us as well, but emotion is subjective so let us keep to the objective numeric proof for now.
The reason that losses carry more significance is because they reduce your principal (the amount of money that is able to earn future interest). This concept is actually also exemplified in our first example by looking at the first 2 years returns (+50% and -50%). If gains and losses carried the same weight, then our resulting account balance would be unchanged after those 2 years of returns… but that is not the case, is it? Regardless of which comes first, the result is as follows:
$100 + 50% = $150 à $150 – 50% = $75 (Average Return = 0%, Real Return = -25%)
$100 – 50% = $50 à $50 + 50% = $75 (Average Return = 0%, Real Return = -25%)
Furthermore, a 50% loss actually requires a 100% gain to be offset. A 30% loss requires a 43% gain. A 25% loss requires a 33% gain. Gains and losses are not apples to apples!
Have you ever heard the story of the goose that lays the golden eggs? The moral is that you can only sell the goose once but, if you protect the goose, you can sell the eggs again and again forever. The same holds true of your portfolio’s principal – your principal is the goose that lays the golden eggs representing your future earnings. If you lose the goose, there will be no golden eggs to see you through your golden years.
So how do these two concepts relate to sequence of returns? The first dispels the myth that our money actually experiences the “average returns” of the market. The second helps us understand the importance of protecting our savings (the principal) in retirement because we now understand that it is the principal that generates our future earnings enabling us to fund our retirement lifestyle.
While the first two concepts are true throughout your career, Sequence of Returns Risk truly begins to be a threat when you start living off of your retirement savings rather than your paycheck.
See, the third element we must introduced to the equation is that retirees no longer have an income! So, while negative returns hurt everyone (mathematically) more than gains help, it is when we begin to rely on our retirement assets to pay the bills that having a negative return really becomes a potential crisis. For those in retirement, market losses are now further compounded by the withdrawals needed to maintain the household income because, unfortunately, our bills don’t wait for bull markets, do they?
So, if you retire into a bear market or recession, the pain of losing principal is compounded by the additional income withdrawals you’re forced to make – further lowering your principal and significantly decreasing the earning potential of your assets in later years… which translates to running out of money earlier in your retirement! No Bueno!
So how do we address Sequence of Returns Risk?
Well, while we cannot control the market and which direction it moves, we absolutely can control our exposure to it. For those nearing retirement or that have recently entered retirement it is critical that you review your personal risk tolerance and compare that with the amount of market exposure that you actually have in your retirement assets. But in today’s still low interest rate environment we cannot forego market exposure altogether and expect to have our earnings outpace inflation, so for those nearing/entering into retirement it is critical that you monitor your investments closely, or set up free automated investment alerts, to protect your principal so that your TSP and IRAs can continue to generate the retirement income you need.
It is in helping you understand and address these lesser-known retirement risks that a Federally Focused Retirement Planner “earns their keep” so to speak – so feel free to reach out today!
(This article originally was posted 2/2/2019 & market conditions may not be the same as they were during the original post date – but the underlying concepts all hold true through changing market environments.)