How does the sequence of investment returns in the years leading up to retirement impact the sustainability of a retirement portfolio?

The sequence of investment returns in the years leading up to retirement can have a significant impact on the sustainability of a retirement portfolio. This phenomenon is often referred to as the "sequence of returns risk" or the "sequence risk." It is primarily related to the concept of market volatility and the order in which investment returns occur.

Here's how the sequence of investment returns can impact the sustainability of a retirement portfolio:

1. Positive Sequence of Returns:If an individual experiences consistently positive investment returns in the years leading up to retirement, their retirement portfolio is likely to grow substantially. This can provide a larger base for generating retirement income and may help sustain the portfolio over time.

2. Negative Sequence of Returns:Conversely, if an individual experiences negative investment returns in the years just before or early in retirement, the portfolio's value may be significantly reduced. This is particularly concerning because withdrawals for retirement income will need to be taken from a smaller portfolio value, and the impact of the losses can be magnified due to these withdrawals.

3. Early Losses Followed by Gains:Experiencing losses early in retirement followed by positive returns can also be detrimental. This is because the portfolio is already reduced due to withdrawals during the down years, and subsequent gains might not be sufficient to recover the losses.

4. Withdrawal Rate Impact:The sequence of returns can impact the withdrawal rate that retirees can sustain. A portfolio that experiences negative returns early on may require lower withdrawal rates to ensure the portfolio lasts throughout retirement. Conversely, a portfolio with strong early returns may allow for slightly higher withdrawal rates.

5. Longevity Risk:The sequence of returns risk is particularly relevant because retirees cannot control when market downturns occur. If a market downturn aligns with the early years of retirement, it can significantly increase the risk of outliving one's savings (longevity risk).

6. Mitigation Strategies:To mitigate the impact of negative sequences of returns, individuals may consider diversifying their portfolio, adopting a more conservative asset allocation as retirement approaches, and having a flexible retirement spending plan that can be adjusted based on market conditions.

In summary, the sequence of investment returns in the years leading up to retirement and early in retirement can heavily influence the sustainability of a retirement portfolio. It's crucial for retirees to be aware of this risk and to plan accordingly by building a well-diversified portfolio, adopting a flexible withdrawal strategy, and considering the potential impact of market volatility on their retirement income. Consulting with financial professionals can also help retirees navigate these challenges effectively.