Navigating Sequence of Return Risk: A Crucial Consideration for Retirees
Retirement is a time when you seek financial security and peace of mind after years of hard work. However, one significant risk that retirees face is the sequence of returns, also known as sequence of return risk. This risk refers to the timing of investment returns during the early years of retirement and its impact on the sustainability of a retirement portfolio. In this blog, we'll delve into the concept of sequence of return risk, its potential implications, and strategies to mitigate its impact.
Understanding Sequence of Return Risk
Sequence of return risk arises from the fact that market returns can vary widely from year to year. Retirees who experience poor investment returns in the early years of retirement face a higher risk of depleting their portfolio prematurely. This is because when portfolio values are low due to poor returns, retirees must withdraw funds for living expenses, potentially locking in losses and reducing the portfolio's ability to recover in the long run.
Implications of Sequence of Return Risk
The impact of sequence of return risk can be profound. If retirees experience significant investment losses early in retirement, they may be forced to withdraw a higher percentage of their portfolio to cover living expenses. This can lead to a faster depletion of assets and a reduced ability to generate sufficient income to sustain retirement throughout their lifetime. Retirees who encounter negative returns in the initial years face a more challenging path to recovery, as the compounding effect of negative returns can be difficult to overcome. Take a look at the following chart, it shows the impact of negative market returns early on in your retirement if you don’t have a distribution plan in place.
This chart shows a hypothetical account balance of $693,824 at retirement with $35,000 in income being withdrawn each year. The two charts use the same set of annual returns, the only difference is the order of the returns has been reversed between the two to show the effects of strong early returns compared to negative early returns.
Mitigating Sequence of Return Risk
This is where the importance of having a retirement plan comes into play. There are strategies retirees can employ to mitigate this risk and enhance the sustainability of their retirement portfolio. Taking the time to develop an income distribution plan ensures a steady and reliable source of income throughout retirement, providing peace of mind and financial security.
Start with the Bucket Strategy
Segment your money into retirement buckets- the money you plan to use within the next 5 years, the money you want to be set aside for the next 5-15 years, and then the money that will stay invested for the next 15+ years. Each of these buckets should have its own investment strategy and asset allocation that is constantly changing as you are spending down your income bucket.
Diversify your Investments
A well-diversified portfolio that includes a mix of asset classes, such as stocks, bonds, and cash equivalents, can help reduce the impact of poor returns in any one asset category. Diversification can help cushion the blow during market downturns and provide stability to the overall portfolio
Maintain an Emergency Fund
Maintain an emergency fund or cash reserve that covers a few years' worth of living expenses. By having this buffer, retirees can avoid tapping into their investment portfolio during market downturns, allowing time for the portfolio to recover.
Consider Guaranteed Income Sources
Explore options for guaranteed income sources, such as annuities or pension plans. These can provide a steady stream of income regardless of market performance, helping to mitigate the impact of poor investment returns during retirement.
Plan for Longevity
Plan for a longer retirement horizon by considering life expectancy, healthcare costs, and long-term care needs. Longevity insurance or long-term care insurance can help protect against unforeseen expenses and provide peace of mind.
Regularly Review Your Portfolio
Regularly review and rebalance your investment portfolio to ensure it aligns with your risk tolerance and retirement goals. Rebalancing can help maintain a diversified allocation and reduce exposure to excessive risk.
Seek Professional Guidance
Consult with a qualified financial advisor or retirement specialist (ahem, raising my hand here) who can help you analyze your specific situation, assess the potential impact of sequence of return risk, and develop a tailored retirement strategy that addresses your unique needs and goals.
Sequence of return risk is a crucial consideration for retirees as they plan for a financially secure retirement. By understanding the implications of this risk and implementing appropriate strategies, retirees can minimize the impact of poor market returns during the critical early years of retirement. Don’t feel like you have to do this alone. Connect with us for valuable insights, personalized strategies, and ongoing support to help you make informed decisions and achieve your retirement goals. Start planning today to secure a brighter future tomorrow.
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.