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The Order of Returns: The Most Overlooked Retirement Variable

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Any client that has ever worked with a financial advisor before has undoubtedly seen some sort of illustration or projection on what their investments MAY look like at some time in the future. Those projections become an integral part of your overall financial strategy for how much and when to start drawing your valuable retirement savings. More often than not these illustrations show a flat rate of return, for example it may show an average rate of return of say 7% and each and every year your assets grow by exactly 7%. Be aware though, this could lull you into a false sense of security or reality. Here is why.

Reason 1: Never has the market returned the exact same rate of return in multiple, consecutive years. Is it completely possible that in the above mentioned scenario an investor may over a certain period of time average 7% per year? Absolutely. However over that period of time your portfolio is highly likely to have ups and downs, a far cry from that cozy illustration you may have been shown. Advisors that practice this method are not doing you any favors. As an investor you must be willing to accept investment risk and the appropriate value fluctuations that come with that risk. It goes a long way to see one, or multiple, down years during your retirement as it can serve as a reference point for when the inevitable bad market year happens. If your financial strategy can withstand multiple down years chances you are on solid financial footing.

 Reason 2: The order of returns matters. Even if your advisor is showing you an illustration or projection that shows multiple down years, be mindful to pay attention to the order in which these returns occur. Lets take a look at how this would play out in a real life scenario. Say you started with an investment account of $100,000 and you are planning to take $3,000 per year income. If market returns were -10%, 5% and 10% you ending account value after those three years would be $94,185. However if we simply flip the returns to 10%, 5% and lastly -10% you would have an account value of $95,415. So why the difference?

In years that you are taking income, lets say in the first year of the example above, if you had a negative year your account would have dropped to $87,000 ($10,000 in market losses and $3,000 of income). You would need to achieve a 19% rate of return the following year simply to breakeven. If it was a positive 10% year, after the first market year, you account would be $107,000 ($10,000 market gains minus $3,000 of income). A $20,000 swing in the first year of retirement simply by changing the order of returns. 

So what can you do? Simple, make sure that you are seeing multiple projections. If your overall investment strategy can withstand the most adverse projection than chances are your are on solid footing. If your advisor doesn’t show or at least talk to you about the importance of the order of returns then you may want to consider seeking another opinion. As of writing this post (January 15, 2021) the markets remain near all-time highs and as such the chance of a client retiring this year experiencing a down year in the market their first retirement year remains a very real possibility. Take the time to understand how the what-ifs will effect your savings. Knowing before you pull the retirement trigger that your investments are suited for early market down years could set your mind more at ease as you move into the next stage of your life.