What Is Sequence Risk and How Could it Affect My Retirement?
Ideally, leaving the workforce and transitioning to retirement will involve financial and emotional preparation. After decades of saving, it is now time to turn our investments into income that will last throughout our lifetime. Because living comfortably in retirement means never being at risk of running out of money, gaining an understanding of how much retirement income is needed throughout retirement is critical.
Withdrawal rates that are “safe” for the longevity of our retirement portfolio are dynamic, not static. Not only will the circumstances of your life change along the way, but so will market returns, interest rates, and inflation. Political, social, environmental, or economic changes can have a great impact on the markets, and in turn, expose your portfolio to risk. Incorporating these risks into your retirement planning will better prepare you for retirement and allow you to make appropriate adjustments along the way to keep on track for continued success.
Sequence of Return Risk
The sequence of investment returns and inflation during the early years of retirement will have an enormous impact on a retiree’s financial security. There is a real risk of experiencing low or negative returns early in retirement just as withdrawals begin. Years of negative returns could (1) deplete a portfolio faster than desired or expected and/or (2) create a need for retirees to spend less than anticipated.
It should be noted that sequence of returns also has tremendous upside potential should the market have positive investment returns throughout the first few years or decade of retirement. While a negative sequence of returns could result in an undesired reduction in retirement spending or depletion of a portfolio before anticipated, a positive sequence of returns could quickly compound the portfolio and increase funds available for ongoing withdrawal and legacy goals.
Sequencing risk will cause safe withdrawal rates to vary, sometimes significantly! Because sequence of returns is determined by the date portfolio withdrawals begin, they cannot be known and factored in ahead of retirement.
The challenge then is to determine a reasonable amount of spending that can withstand a potential downturn should one occur right before or right after we retire, but to also position the portfolio to capture the benefits of an upswing should one occur. Let’s take a closer look with an example.
Defending Against Sequence Risk
For illustrative purposes, let’s say two retirees each start with $1,000,000 in investment savings. They each withdraw 6% a year for 4 years, with one retiree having an ending balance after four year of $720,000. The other retiree fares much better with an ending balance of $831,768.
What caused the difference of $111,768? Simply put, sequence of returns.
The higher losses realized in the market when the first retiree began withdrawing funds compounded. Drawing down on a lower portfolio amount decreased the value of the portfolio and made it significantly harder to recover due to lost time of principal in the market. Not only can sequence of returns negatively impact the longevity of a portfolio, but can also affect the legacy available to leave behind to heirs
Returns Don’t Tell the Whole Story
Keep in mind, returns don’t tell the whole story. The average long-term historical return of the S&P 500 index since 1926 is around 10%. However, this is only an average annual return. The S&P 500 has seen a one-year return as high as +38% (1958) and as low as -38% for an annual return (2008).
While these extreme high and low returns are outliers, it is to illustrate that even if two retirees have the same long-term average returns, the retiree that retires in a bear market is subject to sequence risk and could potentially forfeit hundreds of thousands of dollars.
Does Sequence Risk Affect my Accumulation Years?
Sequence risk doesn’t impact your portfolio during accumulation years, since you’re adding to your retirement savings. In fact, if you are automatically deferring into an investment account on a schedule, you take advantage of market declines in your accumulation years by purchasing more shares at cheaper price points when markets decline. Once the markets recover, you’ll have more shares owned to expose to the powers of compounding over time.
Ways To Hedge Against Negative Sequence Risk
While no one can predict what the market will do when it comes time for you to retire, the economic or political dynamics throughout your retirement, or how long you will live, there are ways to strategically hedge against sequence risk.
1. Keep a Cash Reserve
In addition to having a liquid emergency fund, consider having a portion of your portfolio in cash and liquid investments. Set aside the first few years of living expenses in case a down market occurs at an inopportune time. This way, you can avoid drawing down your investment portfolio when conditions are less favorable.
2. Diversify Your Portfolio
It is important to allocate your assets to an appropriate risk/reward ratio given your expected investment time horizon and goals. Having an appropriate portion of your portfolio consistently in stable investments like short to intermediate term high quality government, corporate, or municipal bond funds (i.e fixed income) will provide a reliable place to take your distributions in down markets.
Instead of reinvesting interest and dividend distributions within the bond and stock holdings, these can be held in cash and not reinvested in shares. This can be used as the first source of funding toward portfolio distributions.
Following years with a positive return where an equity asset class exceeds its target allocation, the excess appreciation can be sold and the proceeds invested in cash to meet future withdrawal needs. Withdrawals should not be taken from any equity asset during or following a year in which it had a negative return if cash or fixed income assets are sufficient to fund the intended withdrawal.
3. Reduce Spending
Reducing discretionary spending (dining out, entertainment, travel, gifting) during market turmoil is an important strategy to allow your portfolio to rebound. Often this is a very natural reaction when there is stress in the economy and markets. Plan to reduce portfolio distributions to fund your retirement income needs by 10-15% during down markets.
4. Continue Working
If you are about to enter retirement and market conditions are not the most favorable, consider postponing your retirement date and working longer. If you are in your highest earning years, this could give your Social Security benefits a boost and allow your invested funds to continue growing until market conditions improve.
There are other benefits to working full or part-time during retirement, as well, including improved mental health, potentially accessing employer-subsidized health insurance for a longer duration, and continuing to make contributions to your retirement accounts.
Correct and Adjust as Needed
Ensure you are revisiting your plan ongoing. You may need to adjust your strategy based on actual results. You may want to consider increasing your spending only during years when your portfolio grows in value or decreasing spending in years when performance is negative. Having a retirement income strategy alongside an appropriate asset allocation for your situation, ensuring proper portfolio diversification, regular portfolio rebalancing and adjustments along the way will all help keep us on track for continued success throughout retirement.
Interested in learning more about how we help clients plan for this and other retirement risks? We encourage you to take a look around our website and see the types of clients we serve best.
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