Topic 7 – Sequence of Returns Risk and Your Income

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I’d like to share with you in the following slides, two examples of hypothetical returns that illustrate clearly what sequence risks can do. I think it will be an important question for you to ask at the end of these slides, is, is this the first time I’ve heard of sequence risk? And is this the first time it’s been defined to me? If I go to my current source of financial advice and they say, sequence of returns risk will not affect me. Then you’re probably working with a financial advisor that’s more interested in accumulation of your wealth and not considering now that we’re moving into the distribution phases of your wealth during retirement. In this slide, we see how sequence of returns risk can compromise your income. We have two families that have retired. They retired at the same time with $1 million. Couple number one retires in their year one, and they get a positive return of 27% followed by 9% positive, 7% positive and then in year four, have a 15% negative. Couple number one is illustrated in the gold line above. Couple number ones money lasts out about 37 years before they hit a zero balance because that sequence of returns continues in a cycle in this hypothetical example, every four years for their complete retirement timeframe. Couple number two, however, receives a sequence of returns that’s reversed from couple number one. They experienced the negative 15% first, followed by a positive 7%, then a positive 9% and 27%. Couple number two has the same average rate of return is couple number one, because when you average both of these rates of return, doesn’t matter what sequence they happen in, they both receive a 7% average annual return. So let me make a point here about average rates of return. We can’t predict our future income and how long it lasts based on past performance of the stock market.

If we look at average rates of return, that’s not what we’re going to receive in the 20, 30, 40 years of retirement. We will not get an average 7% every year. We’ll have positives, we’ll have negatives and we have no control over what years we’ll receive positives or negatives. So let’s go back to our example here and see how these theories apply. If we look at the couple two, because of their sequence, starting out with negative and repeating that same four year sequence through their retirement, their money only lasts 24 years. Now, let’s assume, without inflation, that both couples were taking out $50,000 per year. It would be a simple math example to determine that I would much rather be couple number one. My money lasted 13 years longer than couple number two, and it was a total of $650,000 more that couple number one could spend in retirement. Let’s just think about this a minute. Which couple would you rather be? And do you agree that sequence of returns risk needs to be factored in and dealt with so that we don’t have to experience negative sequence of returns risk in our retirement income planning.