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In the words of former US Secretary of Defence Don Rumsfeld, there are “known knowns, known unknowns, and unknown unknowns”. Sequencing risk falls into the “known unknowns” category – we know market fluctuations will happen, but we can’t predict their timing or severity.
This uncertainty is especially relevant for doctors transitioning from a stable, high-income career to the unpredictability of retirement.
Sequencing risk, or the risk of poor investment returns early in retirement, can significantly affect the longevity of retirement savings. For medical professionals nearing retirement, understanding and addressing this risk is essential to maintaining financial security.
By recognising the potential impact of early negative returns and planning accordingly, doctors can better safeguard their savings and enjoy a more stable retirement.
This article explores sequencing risk, its implications for retirement planning, and strategies to help retiring doctors navigate this financial challenge.
What is sequencing risk?
Sequencing risk refers to the danger that the order and timing of withdrawals from your retirement account will negatively affect the overall rate of return on your investments.
This risk is particularly relevant during the initial years of retirement when you start withdrawing funds from your portfolio. If the market experiences a downturn during this period, the value of your investments can be significantly reduced, leading to long lasting impacts on your retirement savings.
Sequencing risk at play
To illustrate sequencing risk, let’s consider two hypothetical retirees, Dr Smith and Dr Jones, both with a retirement portfolio of $5 million.
They each plan to withdraw $250,000 annually, adjusted for 2.5% inflation each year.
Scenario 1: Early market downturn
- In the first two years of retirement, Dr Smith’s portfolio experiences a 15% decline each year, followed by a 6% annual return for the next 16 years. After 18 years, Dr Smith’s portfolio is reduced to $62,671.
- Dr Jones enjoys a 6% annual return for the first nine years, followed by a 15% decline in the 10th and 11th years, and then a 6% return for the remaining years. After 18 years, Dr Jones’s portfolio still has a significant balance of $1,926,018.
After 18 years, Dr Smith’s portfolio is essentially depleted, while Dr Jones still has a significant balance.
This example highlights how early losses can severely impact the longevity of a retirement portfolio, while mid-retirement downturns may be less detrimental if the portfolio has already grown.
Scenario 2: Early market downturn with additional expenses
In this scenario, Dr Brown and Dr Green both start with a retirement portfolio of $4 million. They each plan to withdraw $175,000 annually, adjusted for 2.5% inflation each year.
- In addition to the annual living expenses, Dr Brown incurs a big European trip costing $100,000 in the first year and financial support of $300,000 for their children in years two and four. Their portfolio experiences a 10% decline in the first year and an 8% decline in the second year, followed by a 6% annual return for the next 16 years. After 18 years, Dr Brown’s portfolio is reduced to $328,392.
- Dr Green has the same additional expenses but funds them at a later stage – years 11, 12, and 14. Dr Green enjoys a 6% annual return for the first nine years, followed by a 10% decline in the 10th year and an 8% decline in the 11th year, and then a 6% return for the remaining years. After 18 years, Dr Green’s portfolio still has a balance of $2,010,797.
This example highlights how the timing of additional expenses, combined with the sequence of returns, can severely impact the longevity of a retirement portfolio.
Early losses and early additional expenses can drastically reduce the portfolio’s value, while delaying these expenses can help preserve the portfolio’s balance.
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Impact on retirement planning
Sequencing risk can have profound implications for your retirement planning, including:
- Depletion of savings: As seen in the examples, an early market downturn can lead to a faster depletion of your retirement savings. This is because you are withdrawing funds from a shrinking portfolio, leaving less capital to recover when the market rebounds.
- Reduced financial security: The risk of running out of money can lead to financial insecurity, forcing retirees to adjust their lifestyle or spending habits unexpectedly. This can cause emotional stress and anxiety, undermining the peace of mind that should accompany retirement.
- Impact on withdrawal strategies: Fixed withdrawal strategies, where a set amount is withdrawn annually, can be particularly vulnerable to sequencing risk. Retirees may need to adopt more flexible withdrawal strategies that adjust based on market performance to mitigate this risk.
Mitigating sequencing risk
While sequencing risk cannot be entirely eliminated, there are strategies to mitigate its impact:
- Ensure your investments are spread across various asset classes to reduce risk. A well-diversified portfolio can help cushion the impact of market downturns. Including a mix of stocks, bonds, and other assets can provide stability and reduce the overall risk to your retirement savings.
- Continuously review and adjust your asset allocation to ensure it aligns with your risk tolerance and retirement goal.
- Plan around lump sum expenses.
- Adjust withdrawal rates – be flexible with your withdrawal rates, reducing them during market downturns to preserve capital.
- Maintain a cash reserve – having a cash reserve can help cover expenses during market downturns, allowing your investments time to recover.
For medical professionals nearing retirement, understanding and planning for sequencing risk is crucial.
By being aware of this risk and implementing strategies to mitigate its impact, you can better ensure the longevity and security of your retirement savings. Remember, the key to a successful retirement is not just about accumulating wealth but also about managing risks effectively.
Does your investment strategy need a financial check-up? If so, reach out to drossbach@capital-partners.com.au
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