What's more important to your clients, rate of return or order of return? The gut reaction of nearly every financial advisor is rate of return. But for your clients in the second half of their financial lives, I argue that order of returns (also known as the sequence of returns) is every bit as important as rate, and is potentially the biggest retirement risk of which your clients are unaware.
Consider the following scenario…
A well-educated, 35-year-old professional walks into your office to discuss basic retirement planning. He'll do what it takes to retire with $1 million in savings (supplemented by Social Security) at age 65. Furthermore, he's able to contribute $5,000 annually into the best retirement accounts you recommend. Over the long run you agree that a 9 percent rate of return may be attainable.
Fast forward 30 years, and your client is now 65. As planned, he diligently invested $5,000 per year through your firm and due to your infinite wisdom and incredible financial acumen, you didn't just average a 9 percent rate of return, you averaged 9.68 percent (S&P 500 average 1980-2010). Your client should have over $1 million in his accounts.
Sitting down with the new retiree, you total all his accounts and statements. But something doesn't look right. Instead of $1 million or $800,000 or even $600,000, you keep coming up with a much lower number. How did your calculator just total $562,281 three times in a row? What happened? This is a good example of the biggest risk— sequence of return risk—you may not be considering, which has helped implode your client's retirement plan.
When you think about it, sequence of return risk makes sense. When investors have the smallest account balances (the early years) you'd prefer the lowest rates of return. As deposits rack up, balances grow larger and retirement comes closer, larger returns are desired. This is the "Retirement Red Zone" and where the final few years before retirement can make or break a lifetime of hard work.
Consider the two charts here. Both were created using the same afore-mentioned 9.68 percent rate of return and take into consideration $5,000 annual deposits. The only difference between Chart 1 and Chart 2 is the order of returns.
Chart 1 displays early savings periods producing the largest return on the smallest amounts of money. Those returns are later upstaged by small or negative returns on the largest investment amounts.
