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Portfolio Perspectives

Explore the intersection between timely topics and potential effects to your investments in Portfolio Perspectives reports.

Beyond Portfolio Average Return

Investment Implementation

David Furst, CFA, Advice Strategy
Taylor McLeod , Analyst

With retirement comes an important shift in a client's financial picture — instead of accumulating wealth and saving money, an investor may begin withdrawing money on which to live. As clients enter this distribution phase of their plan, portfolios can be especially susceptible to an investment risk called sequence-of-returns risk. Sequence-of-returns risk affects investors who are actively withdrawing money from their investment portfolio: it represents the possibility that their investments may produce low or negative returns soon after initiating withdrawals. A market decline in the early years of retirement, coupled with simultaneous withdrawals, can create a situation where there is not enough time to rebuild the investment’s value, even if positive returns occur later.

Hypothetical Example

Mary and John both (1) retire with a $1million investment portfolio (2) withdraw $50,000 annually, and (3) experience a five-year average return of 6%.

This chart depicts an illustration of two hypothetical portfolios both retiring with $1 million and withdrawing $50,000 annually. Their portfolios produce the same annual returns, but in reverse order. The bar chart represents each portfolio’s return over five years, and the line chart represents the balance in the portfolio. For more information, please contact your Financial Advisor or the Investment Resource Center at 1-866-975-0166.Source: Wells Fargo Advisors. The illustration is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of any future results. Past performance does not guarantee future results.

In the two hypothetical scenarios discussed, Mary and John both retire with $1 million portfolios and withdraw $50,000 annually. Their portfolios also produce the same annual returns, but in reverse order (i.e., Mary’s portfolio returns 16.7% during the first year and -25.6% the last, while John’s returns -25.6% the first and 16.7% the last). Although their five-year returns both average to 6%, Mary ends with $134,485 more in portfolio value than John. The only difference is the order, or sequence, of the annual returns.

Portfolio Returns and Dollar Value

These tables depict a hypothetical example of two portfolios retiring with $1 million and withdrawing $50,000 annually. Their portfolios produce the same annual returns, but in reverse order. The first table represents the portfolio returns over five years, and the second table represents the dollar value of the portfolios over five years. For more information, please contact your Financial Advisor or the Investment Resource Center at 1-866-975-0166.Source: Wells Fargo Advisors. The illustration is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of any future results. Past performance does not guarantee future results.

Scenario 1: Positive returns in the early years if investment

In scenario 1, Mary began her retirement with a $1 million equity and fixed income investment portfolio and made $50,000 annual withdrawals over the course of five years. Mary retired during a strong market and her portfolio experienced (or “produced”) three years of positive performance followed by two years of market losses. After five years, Mary’s account value was $1,010,110 — slightly higher than the amount she started with at retirement.

Scenario 2: Negative returns in the early years if investment

Like Mary, John also began his retirement with the same $1 million equity and fixed income investment portfolio and made $50,000 annual withdrawals over the course of five years. In this scenario, however, John retired in a down market. During the first two years of his retirement, John’s investment portfolio experienced market losses, returning -25.6% the first year and -1.5% the second. Although the markets rebounded during the next three years, the first two years of negative returns, combined with his annual monthly withdrawals, eroded his account value to $875,625 after only five years.

Early losses in a sequence of returns can affect your retirement

When clients begin withdrawing money from an investment portfolio, the first few years of returns can greatly affect how long their savings will last. Although both Mary and John began with $1 million in retirement savings, withdrew $250,000 during the first five years of their retirements, and realized the same average return over the five years, Mary ends up with $134,485 more in portfolio value than John. What caused their ending account values to differ? The only difference between the two scenarios was the order, or sequence, of annual returns — the returns occurred in reverse order.

It is important to manage your exposure to sequence-of-returns risk

There are a number of ways that could potentially help safeguard your retirement savings from sequence-of-returns risk:

  • Maintain diversified sources of potential income
    Having various types of potential income sources for your retirement – such as guaranteed, stable, and growing – can help pursue the retirement you envision.

  • Develop a dynamic spending strategy
    You can’t predict future market performance or rates of inflation, but you can set up a dynamic spending strategy. Your annual withdrawal amounts can change to reflect inflation and market returns.

  • Build a cash reserve
    A safety net will help you take care of yourself financially in retirement.

  • Create a written retirement strategy
    There’s never a better time to sit down and take control of your future.

Although no one can control how the markets will perform, clients can work with their Financial Advisor to evaluate their investment portfolio’s exposure to sequence-of-returns risk. Understanding their risk factors can help clients make adjustments along the way as life, and the markets, continue to change.

At Wells Fargo Advisors, we believe it’s our job to match your vision of retirement with a plan to pursue it. Call your Financial Advisor today to learn more about the benefits of creating diversified income sources, a dynamic spending strategy, a cash reserve, and a written retirement strategy.

RESEARCH, CHARTS, AND ILLUSTRATIONS PROVIDED BY JUANA DIEZ DE ONATE – WEALTH & INVESTMENT MANAGEMENT ANALYST

Risk Disclosure

This material has been provided for informational purposes only and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Investing involves risk including the possible loss of principal. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification does not guarantee profit or protect against loss in declining markets. Since each person’s situation is different you should review your specific investment objectives, risk tolerance and liquidity needs with your financial professional before selecting an appropriate savings, investment or withdrawal strategy.

Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.2021 Wells Fargo Clearing Services, LLC. All rights reserved.