Of the biggest risks to your retirement, behavior, inflation, taxes, longevity, and sequence of returns, perhaps the least talked about is sequence of returns risk. But it can have just as much impact on your retirement as the other risks. We’ll discuss sequence of returns risk and how you can protect your retirement.
What is Sequence of Returns Risk?
Sequence of returns risk is the risk of a market downturn happening in the last few years before you retire and/or during the first few years of your retirement. A down market in those critical years can have a negative impact on your retirement savings.
Let’s look at an example:
Two investors go into retirement with $1 million each and plan to withdraw $50,000 a year for living expenses. Over the next 30 years, they both have the same average rate of return (6.3%), but their annual returns happen in the opposite order.
Investor A sees three years of down markets at the beginning of retirement, and it leaves him with half of his savings. The market has good years later, but his portfolio is never able to recover and he runs out of money eventually.
Investor B experiences the opposite. Her first few years of retirement see up markets, and while there are down markets over the thirty years she’s retired, her money doubles to more than $2 million.
If neither investor had to take withdrawals, they would have had the same $2+ million balance at the end of 30 years, regardless of the sequence of their returns. However, because they were withdrawing $50,000 each year, their real rates of return were very different from their average rate of return.
This is what each investor experienced:
Ways to Mitigate Sequence of Returns Risk
There are many things we can’t control, and market returns are one of them. But there are things we can do to help mitigate sequence of returns risk.
Reducing spending is one approach to deal with a down market. The less money you withdraw, the more money will remain in your portfolio to experience any market recoveries.
Also known as the guardrails or flexible spending approach, it’s a withdrawal strategy that allows retirees to manage their spending and portfolios during retirement. By setting specific upper and lower limits on withdrawal rates, retirees can maintain a balance between spending and preserving their assets while adapting to fluctuations in the market and their lifestyles.
Keep Cash Reserves
It’s recommended to keep an emergency fund containing three to 12 months of essential expenses (depending on your personal situation), but that applies to your working life. The worst-case scenario for dipping into an emergency fund is a period of unemployment. But even in a recession, most people will be able to find a new job well within twelve months.
Things are different when you’re retired. You need a few years of essential expenses to dip into if your last few working years or first few years of retirement see down markets. This allows you to leave your investments untouched so they can recover.
The problem with cash is that there is no return, which can increase inflation risk later. A middle-ground solution is low-risk investments like bonds or CDs.
Bond laddering entails buying bonds with different maturity dates. Just as the rungs on a ladder have different heights, the bonds in a ladder have different maturity dates. Bond laddering can help reduce sequence of return risk and interest rate risk.
Here’s an example of a bond ladder:
You have a portfolio containing four bonds, each with a different maturity date. The dates are 2024, 2025, 2026, and 2027. During a down market, you may take the money from your 2024 bond maturing and buy a new rung, maybe a bond with a maturity date in 2028.
The point of a bond ladder is you have this money when a bond reaches maturity, and you can work it into your overall investment strategy. That doesn’t necessarily mean making another investment. You might need that money to top off a recently depleted cash reserve or just want to keep it as cash on hand for whatever reason.
The bucket strategy sees investors who are nearing retirement, one to three years out, split their assets into three different portfolios (buckets). Each bucket serves a different purpose and has a different time horizon, asset allocation, and risk level. Splitting up your assets into these buckets allows you to use some assets for income while other assets continue to grow.
Short-term bucket: Helps meet income needs and acts as your cash reserve for the first one to five years of retirement. The assets inside are conservative and won’t be severely impacted by a down market. These assets can include things like money market funds, CDs, and short-term bonds.
Intermediate bucket: Helps provide income for years 6 to 15 of retirement. This bucket can fill the short-term bucket if it’s been depleted. This bucket’s risk level is higher than your short-term bucket and can include assets like dividend-paying stocks, individual bonds, bond funds, and laddered bond portfolios.
Long-term bucket: Helps provide income for years 16 and beyond. This bucket has the highest-risk assets and the longest time horizon, so it has the best chance to recover from down markets. The long-term bucket can include things like equities, commodities, and real estate.
Have a Flexible Plan
When dealing with any risk to your investments, sequence of returns risk, or any others, having a flexible plan that allows for adjustments is the best defense. A solid financial or retirement plan has accounted for different circumstances, including sequence of return risks and the other four big risks to your retirement.
That stated, any good plan also has room for tweaks and changes. While sticking to your plan is one of the most important factors in financial success, the ability to pivot when necessary is important, too.