Sequence of Returns Risk <em>A Crucial Factor for Retiring Engineers</em>
When you’re designing a system, whether it’s a stable power grid or a precise manufacturing process, you’re always accounting for one thing: fluctuations. You know that consistent performance isn’t just about averages—it's about handling those moments when things go awry. In retirement planning, the concept is no different. Enter the Sequence of Returns Risk (SoRR)—a topic that, like the coefficient of thermal expansion in materials, can make or break your retirement success.
What is Sequence of Returns Risk?
Let’s start with the basics. Sequence of Returns Risk is the risk that the order in which you experience investment returns will significantly impact the longevity of your retirement portfolio. Think of it like this: Imagine you’re an engineer overseeing a new power plant. If the power output fluctuates wildly early on when your reserve batteries are low, you might find yourself in trouble. However, if those fluctuations happen later, once everything is running smoothly, you’ve got a better chance of keeping things stable.
In retirement, SORR works similarly. If the market takes a nosedive right after you retire and you’re forced to withdraw from your investments during those downturns, it can permanently erode your portfolio. Conversely, if those downturns happen later when your investments have already grown, the impact is less severe.
The Engineering Analogy: Flywheels and Hot Water Tanks
Now, let’s nerd out a bit. In any engineering discipline, buffers are built into systems to protect steady-state distribution from fluctuations. Take a flywheel, for example. In mechanical systems, a flywheel stores rotational energy, smoothing out the delivery of power and compensating for fluctuations in the system. Or consider a hot water tank—it holds a reservoir of heated water to ensure that when there’s a surge in demand, you don’t end up with a cold shower. These systems are designed with buffers because engineers know that consistency is key.
In retirement planning, your cash buffer serves the same purpose. Just like a flywheel absorbs energy fluctuations, a cash reserve absorbs market volatility. Having a cash reserve of 3-10 years of net living expenses allows you to avoid selling investments in a downturn, giving your portfolio time to recover.
The Math Behind SORR
Engineers love numbers, so let’s dive into the math. Suppose you retire with a portfolio of $1 million and plan to withdraw $50,000 annually, adjusting for inflation. If the market drops 20% in your first year of retirement, your portfolio would shrink to $750,000 after your withdrawal. The following year, even if the market rebounds by 20%, your portfolio only recovers to $900,000 before your next withdrawal. You’re now at risk of running out of money sooner than planned.
Compare this to a scenario where the market gains 20% in the first year and then drops 20% in the second year. You’d be sitting on $1,140,000 after the first year and $912,000 after the second—still above your initial $1 million. The order of returns matters significantly, especially in the early years of retirement.
Building Your Retirement Flywheel: The Cash Buffer Strategy
Just as you wouldn’t design a power grid without a backup system, you shouldn’t enter retirement without a buffer to protect against SORR. This is where the cash reserve comes in—a critical component of your financial flywheel.
Determine the Buffer Size: Start by calculating your annual living expenses. A general rule of thumb is to have 3 to 10 years of net expenses in cash or near-cash equivalents (like short-term bonds or CDs). The exact size depends on your risk tolerance, expected expenses, and other income sources like Social Security or pensions.
Allocate the Buffer: Once you know how much you need, set aside that amount in a low-risk, easily accessible account. This might seem counterintuitive, especially if you’re used to investing everything for maximum growth. But remember, this is your buffer, not your growth engine. Its purpose is stability, not returns.
Use the Buffer Wisely: Only dip into this reserve when markets are down, and replenish it when markets are up. This approach allows you to avoid selling investments at a loss during downturns, preserving your portfolio’s long-term growth potential.
The Engineering Challenge: Monitoring and Adjusting
Like any well-designed system, your retirement plan isn’t a set-it-and-forget-it deal. Just as you’d monitor a system’s performance and adjust for changes in load or input, you’ll need to keep an eye on your portfolio and cash reserves. If you experience a significant market downturn, you might need to adjust your spending or delay large withdrawals to extend the life of your portfolio.
One strategy is to periodically review your withdrawal rate and compare it to your original plan. If your portfolio has taken a hit, consider reducing your withdrawals for a few years until the market recovers. This is akin to reducing load on a system during peak demand periods to prevent overload.
Why DIY Engineers Shouldn’t Go It Alone
Here’s a truth that might sting: even the most meticulous engineer can benefit from an outside perspective. You wouldn’t troubleshoot a complex system without a second set of eyes, so why treat your retirement any differently? A Certified Financial Planner (CFP) brings expertise in areas you might not have considered, such as tax-efficient withdrawal strategies, Social Security optimization, and yes—mitigating Sequence of Returns Risk.
Plus, a CFP can help you stay disciplined during those inevitable market downturns, ensuring that your well-engineered plan doesn’t get derailed by emotional decision-making.
Engineering a Resilient Retirement
In the world of engineering, success often hinges on anticipating and mitigating risks. Retirement is no different. Sequence of Returns Risk is a critical factor that can dramatically affect the longevity of your retirement portfolio. By building a robust cash buffer and regularly monitoring your plan, you can engineer a retirement that’s resilient to market fluctuations.
So, as you approach retirement, remember this: just as a flywheel keeps your system steady and a hot water tank ensures a consistent supply, your cash buffer is the key to maintaining stability in your financial future. Don’t leave this to chance—engineer your retirement with the same care and precision you’ve brought to every other project in your career.
Citations:
Pfau, Wade D. "Sequence of Returns Risk: A Key Retirement Income Concern." Journal of Financial Planning, vol. 27, no. 2, 2014, pp. 30-39.
Bengen, William P. "Determining Withdrawal Rates Using Historical Data." Journal of Financial Planning, vol. 3, no. 4, 1994, pp. 171-180.
Blanchett, David M., and Michael S. Finke. "Retirement Income Stabilization: How Spending Flexibility Can Make or Break Your Retirement Income Strategy." Journal of Financial Planning, vol. 31, no. 4, 2018, pp. 38-47.
