Is Sequence of Returns Risk the Biggest Threat for Retirees Relying on Portfolio Withdrawals?

Advised to the Canadian government's mandatory RRIF (Registered Retirement Income Fund) rules, individuals in or near retirement often face a critical decision: when and how much to withdraw from their investment portfolios. One of the most pressing risks involves the sequence of returns risk, particularly for retirees relying on portfolio withdrawals for income. This article delves into the implications of sequence of returns and provides insights based on updated research like the Trinity Study.

Understanding Sequence of Returns Risk

The sequence of returns refers to the order in which investment returns are realized over time. Unlike the rate of return, which is the absolute growth of your investment, the sequence of returns considers the timing of gains and losses. For retirees, the impact of a poor sequence of returns can be catastrophic, leading to significantly reduced retirement income and sometimes even depletion of assets before the end of one's life.

The Role of Cyclical Returns in Sequence of Returns Risk

Cyclical returns, which represent typical economic cycles and market fluctuations, play a crucial role in the sequence of returns risk. When poor returns occur early in retirement, it often means that withdrawals are made from a portfolio that has already taken setbacks, potentially leading to a compounded negative effect. However, it's important to note that with the assumption of a certain level of cyclical return, this adverse effect may not persist indefinitely. Markets do tend to recover, and this recovery can mitigate the impact of a poor sequence of returns.

Updating the Trinity Study

The Trinity Study has been a cornerstone in the field of retirement income planning. Published in 1998, the original study explored sustainable withdrawal rates over a 30-year retirement period. While the initial study gained widespread recognition, it has since undergone updates to reflect more current economic realities and better investment strategies. These updates highlight the importance of considering different market scenarios and adjusting withdrawal rates accordingly.

A key update to the Trinity Study involves a revised approach to managing withdrawals during periods of poor returns. According to modern studies and updates, if the initial returns are poor, it does not necessarily mean a complete halt to withdrawals. Instead, the approach involves cutting back slightly on withdrawals, which can help the portfolio recover over time. This adjustment accounts for the cyclical nature of market returns and helps mitigate the long-term damage caused by a poor sequence of returns.

The Impact of Investment Behavior on Sequence of Returns Risk

Investor behavior significantly influences how sequence of returns risk manifests. Poor behavior, such as panic selling during market downturns, can exacerbate the negative effects of a poor sequence of returns. For instance, if a retiree needs to withdraw funds during a recession, those withdrawals would come from a smaller, less diversified portfolio, amplifying the impact of the downturn.

Conversely, sticking to a long-term, disciplined investment strategy can help mitigate the risks. This includes staying invested through market cycles, rebalancing periodically, and maintaining a diversified portfolio. These actions not only capture gains during upturns but also help the portfolio recover more quickly from downturns, reducing the risk of a poor sequence of returns.

Conclusion

While sequence of returns risk is a critical concern for retirees relying on portfolio withdrawals for income, it is not the only or necessarily the biggest risk. The impact of poor sequence of returns can be managed through strategic investment practices and the willingness to adjust withdrawal rates as market conditions change. By understanding and adapting to these risks, retirees can significantly enhance their ability to maintain a comfortable standard of living throughout their retirement years.

For those seeking more detailed insights or specific strategies, consulting with a financial advisor is a crucial step. Advisors can provide personalized advice tailored to the individual's specific financial situation and goals.