Planning for retirement involves navigating complex challenges, particularly understanding the impact of sequence of return risk.

This risk can significantly affect your retirement savings, potentially derailing your financial plans if not properly managed.

As you approach retirement, the timing of market conditions becomes crucial. Even if you've saved diligently over the years, a market downturn at the wrong time can have a profound effect on your retirement portfolio.

It's essential to recognize how sequence of return risk can influence your financial security and explore strategies to safeguard your hard-earned savings.

Key Takeaways

• Sequence of return risk happens when market conditions change as you start taking money from your retirement savings. It can make your money run out faster.
• To deal with this risk, keep a variety of investments and some cash or stable assets. This way, you won't have to sell stocks when prices are low.
• Putting off taking money out of your savings can help. So can having a plan for living costs and maybe working part-time at the start of retirement.
• Having different types of assets helps spread out risk. If one investment does poorly, others might do well.
• Experts suggest keeping enough cash for one to three years' worth of expenses. This keeps you ready during tough times without needing to sell investments at a bad time.

What Is Sequence of Return Risk?

This financial hazard affects your retirement income directly. It occurs due to changes in market conditions right when you start withdrawing money from your retirement account.

If the market goes down early in retirement, you have to sell more investments to get the same amount of cash. This can lower how much money you have for later.

This risk matters because it can change how long your savings last. For example, two investors might both average an 8% return over time but end up with significantly different amounts if one faces market downturns early in retirement while making withdrawals, compared to experiencing those same downturns later in retirement.

The key point? Timing matters a lot in how your portfolio grows or shrinks, especially as you turn investment returns into regular income during retirement years.

How Sequence of Return Risk Impacts Retirement

Sequence of return risk can significantly impact retirement, especially in the early years when negative market returns can deplete a portfolio faster.

It can also create challenges in managing income streams and may lead to the need for more conservative allocation strategies to mitigate this risk.

Early Years of Retirement

The first phase of retirement proves crucial for managing your nest egg. If the market drops and you have to pull out money, it can hurt your retirement portfolio. This problem is called sequence-of-returns risk.

It means if bad market returns come early in retirement, there's less money growing for the future.

Negative returns in the first few years of retirement can have a significant impact on how long your savings last.

You should keep enough cash or stable investments like high quality bonds handy. This way, you don't need to sell stocks when their value is down. Maintaining a properly diversified asset allocation across multiple asset classes that don't all move in the same direction simultaneously helps protect against sequence risk.

Portfolio Depletion Risks

Bad market returns early on can shrink your nest egg faster than planned. If you keep drawing the same amount yearly, you might run out of money sooner.

This risk grows if market volatility continues and interest rates rise, affecting bonds and stocks differently.

To manage this, it helps to have investments in different asset classes. Diversified assets can protect your portfolio from big losses in any one area.

Also, moving some money into safer investments like money market funds or fixed income investments can reduce the chance of running out of cash too soon during rough economic times.

3 Strategies to Mitigate Sequence of Return Risk

Mitigating sequence of return risk is crucial for a secure retirement. Diversifying your asset allocation and maintaining a cash reserve are effective ways to manage this risk.

Delaying withdrawals can also help reduce the impact of market volatility on your retirement assets.

1. Diversified Asset Allocation

A strategic distribution of your assets means allocating investments across different asset classes (stocks, bonds, real estate, etc.), sectors, geographies, and investment styles to reduce correlation between holdings and mitigate various types of risk, including sequence risk.

This reduces risk—if one investment underperforms, others may help balance it out.

It's the classic "don't put all your eggs in one basket" approach, spreading risk across different investments.

By diversifying your assets, you can help protect against losses from any single investment type. For example, if the stock market is down, having some money in bonds or real estate could help balance things out.

Diversification can help reduce your exposure to sequence risk by potentially reducing the impact of a poor annual return in one area during the early years of retirement.

2. Maintain a Cash Reserve

Maintaining a cash reserve is crucial to navigate sequence risk effectively.

Having cash on hand can help cover living expenses during market downturns, reducing the need to sell investments at a loss.

It provides a buffer against short-term market volatility and ensures retirees have funds readily available without relying solely on selling stocks or bonds when their value may be low.

In practical terms, financial advisors often recommend keeping one to three years' worth of living expenses in cash or cash equivalents, such as money market accounts or short-term Treasury bills. However, this strategy should be tailored to individual circumstances, as holding excessive cash can reduce long-term returns due to opportunity costs and inflation risk.

This helps retirees weather market fluctuations without disrupting their long-term investment strategy and retirement income plan.

3. Delay Withdrawals

Delaying or reducing withdrawals during the early years of retirement, particularly during market downturns, can help make retirement savings last longer by preserving principal during the critical early retirement phase when sequence risk is highest. Here are some strategies to consider:

1. Evaluate Your Withdrawal Rate: Assess your annual withdrawal rate and consider reducing it during bear markets or poor performance years to protect your portfolio.
2. Part-Time Work: If possible, consider part-time employment in the early years of retirement to reduce reliance on portfolio withdrawals.
3. Social Security Delay: Consider delaying claiming Social Security benefits to increase future payouts, providing a larger income stream later in retirement.
4. Adjust Spending: Be flexible with your spending and cut back during periods of market volatility to preserve your retirement nest egg.
5. Utilize Guaranteed Income Streams: Opt for annuities or similar financial products that provide a guaranteed income, reducing the need for large portfolio withdrawals early in retirement.
6. Consider Reverse Mortgage: For homeowners 62 and older, a reverse mortgage could be an option to tap into home equity without selling investments during market downturns. However, these products involve significant fees, interest charges that compound over time, and reduce home equity, so they should be carefully evaluated with a financial professional to determine suitability.
7. Health Savings Accounts (HSAs): Use funds from HSAs for medical expenses instead of tapping into the investment portfolio, allowing it more time to grow.

Seek Professional Advice

The sequence of return risk can have a significant impact on your retirement, especially if it hits early in your retirement years. Without a solid strategy, it could reduce the longevity of your savings.

A Farther financial advisor can help you manage this risk, develop a personalized retirement plan, and adjust your investment strategy to minimize the impact of market fluctuations.

Don't leave your retirement to chance—let's build a plan to protect your future.

Talk to an advisor today!

Conclusion

In retirement, sequence of return risk can significantly impact your financial security. The order of investment returns in the early years plays a crucial role in how long your savings will last.

Mitigating this risk through strategic asset allocation and withdrawal planning is key to ensuring a stable retirement income.

Being proactive and understanding the potential impact of sequence of return risk can help you navigate economic uncertainties with greater confidence.

FAQs

1. What is sequence of return risk and how does it impact retirement?

Sequence of return risk is the danger that the timing of withdrawals from a retirement account will harm the investor's overall rate of return. This risk can impact your hard-earned savings, particularly if market conditions are poor in the initial years of retirement.

2. How can I manage sequence risk in my retirement plan?

To protect against timing-related losses, you may consider strategies like having a mix of conservative and growth-oriented investments, or using a target date fund which automatically adjusts your portfolio allocation as you approach retirement. However, target date funds vary significantly in their approaches and fees, and may not be sufficiently personalized for your specific situation and risk tolerance.

3. Does rising interest rates affect sequence risk?

Yes, rising interest rates could affect returns on certain investments like short term bonds, thereby impacting sequence risk and potentially reducing your portfolio value during the early years of your retirement.

4. Can tax planning help mitigate sequence risks?

Yes, strategic tax planning such as understanding when to withdraw from taxable accounts versus tax-advantaged accounts, managing ordinary income versus capital gains tax rates, or utilizing traditional IRAs for tax-deferred growth and Roth IRAs for potentially tax-free withdrawals can help mitigate sequence risk by optimizing after-tax returns and preserving more wealth for retirement spending.

5. How does inflation play into sequencing risks?

Inflation can erode purchasing power over time which means even positive investment returns might not keep pace with rising costs in future years making it crucial to manage sequencing risks for long-term financial health.

6. Are younger investors less affected by sequence risk?

While all investors face market risk, sequence of return risk specifically affects those withdrawing from their portfolios. During the accumulation phase, younger investors benefit from dollar-cost averaging and time to recover from market downturns. However, once withdrawals begin (typically in retirement), sequence risk becomes significant regardless of age, with the greatest impact in the first 5-10 years of the withdrawal phase.

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