Sequence of returns risk involves the order in which investment returns occur and the impact of those returns on people who are near retirement, transitioning into retirement, or recently retired. In a nutshell, a bear market or period of market losses can have a severely negative impact on the income generating potential of a portfolio belonging to a person who is transitioning into retirement. The reason is that people who are transitioning into retirement will—in the near-term—need to begin withdrawing portfolio funds to produce income. As a result, the ability of the portfolio to “catch-up” during subsequent years is greatly diminished, and the person’s longevity risk will likely increase significantly. Hedging or downside protection of one’s financial assets is critical and can help mitigate sequence of returns risk. Assume, for example, that a given 10 year period of market returns: a) is highly volatile; b) begins with a 2 year period of very negative returns (e.g. -40%), and; c) results in an average return at the end of the 10 year period that is 6%. This 6% average return is not necessarily a problem for a person who bought and held during the entire 10 year period. However, it has catastrophic implications for the income generating potential of the person who was set to retire 3 years into the 10 year period. The sequence of the returns or the fact that the losses occurred early in the 10 year period is critical for the person transitioning into retirement.
