Due to various economic factors, planning for a comfortable and financially secure retirement may be challenging. While many are aware of inflation, there’s another significant but less familiar hazard: sequence-of-returns risk, also known as sequencing risk. Understanding and mitigating this risk is crucial for preserving your retirement savings.
What is Sequence-of-Returns Risk?
Sequence-of-returns risk arises from the timing of withdrawals from your retirement portfolio. The market’s natural fluctuations may significantly impact your portfolio depending on when these fluctuations occur relative to your withdrawal schedule.
Why Timing Matters
When you withdraw money from your retirement account, you sell assets such as stocks or bonds to cover your expenses. If the market declines early in your retirement, your assets’ value decreases, and you may need to sell more of them to generate the same amount of cash. This increased sell-off reduces the number of assets left in your portfolio, limiting future growth potential when the market recovers. Conversely, if the market drops later in your retirement, after years of steady returns, the impact of withdrawals and losses is mitigated by the gains accumulated earlier.
Example of Sequencing Risk
Consider two retirees, Jane and John, who both start retirement with $500,000 in their accounts and withdraw $20,000 annually. Jane experiences a market decline early in her retirement, while John’s portfolio faces a downturn later.
Jane’s portfolio encounters a significant market drop in the first two years, reducing her balance to $400,000 despite her withdrawals. Over time, even as the market recovers, the early losses combined with continuous withdrawals significantly diminish her savings.
John, on the other hand, sees steady market growth during the initial years of his retirement, increasing his portfolio to $600,000 before encountering a downturn. By the time the market declines, he has already benefited from years of growth, and the impact of the downturn is less severe on his overall financial health.
This example illustrates sequence-of-returns risk: the timing of market downturns may profoundly impact retirement savings, especially when they occur early in the withdrawal phase.
Strategies to Mitigate Sequence-of-Returns Risk
While market downturns are beyond your control, you may take steps to minimize their impact on your retirement portfolio:
- Continue Working
If you’re nearing retirement and the market is down, consider delaying your retirement until the market recovers. For those already retired, returning to the workforce temporarily may help reduce or suspend withdrawals from your portfolio.
- Add Stability
Incorporate stable investments, such as guaranteed annuities, into your retirement portfolio. While these may offer lower growth, they provide reliable income during market downturns, helping to sustain you without depleting other assets.
- Use Alternative Assets
Rather than selling investments in a bear market, use other assets, like the cash value of a life insurance policy, to meet your expenses. When the market recovers, you may “repay” these funds by taking withdrawals under more favorable conditions.
- Adjust Withdrawal Rates
The commonly recommended 4% withdrawal rate is a guideline, not a rule. During market downturns, consider reducing your withdrawal rate if possible. Cutting back on non-essential expenses temporarily may help preserve your portfolio.
Conclusion
Sequence-of-returns risk is a critical factor to consider in retirement planning. By understanding how the timing of market fluctuations affects your withdrawals and implementing strategies to mitigate this risk, you may better protect your nest egg and enjoy a more secure retirement. Diversifying your investments, maintaining flexibility in your retirement plans, and seeking advice from financial professionals may help you navigate this complex landscape and achieve your long-term financial goals.
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