Understanding Sequence of Return Risk and Its Impact on Retirement
When planning for retirement, most of us focus on saving enough money to last throughout our golden years. However, one key factor that many overlook is sequence of return risk—a phenomenon that can significantly affect how long your retirement savings last, especially in the early years of retirement.
What is Sequence of Return Risk?
Sequence of return risk refers to the potential impact of the order in which your investment returns occur. Even if your portfolio earns the same average return over time, the sequence of those returns can have a dramatic effect on the amount of money you have left in retirement. In simple terms, it’s not just about how much you make, but when you make it.
For example, if you experience large losses early in retirement (when you’re withdrawing money to cover living expenses), it can deplete your savings faster than if those losses occurred later in retirement when you’re no longer drawing as much. The market goes down, you withdraw to make it go down further, and now you have less shares for the recovery.
Why is it Important?
The timing of investment returns is critical, particularly when you are drawing down from your retirement funds. If your investments perform poorly in the first few years of retirement, it can reduce the base of your portfolio, making it harder for the remaining assets to recover in the future. On the other hand, strong returns early on allow your portfolio to grow, potentially giving you a cushion to weather any downturns later.
Mitigating Sequence of Return Risk
While we can’t control market returns, there are strategies to help mitigate sequence of return risk:
- Diversification: A well-diversified portfolio across different asset classes can reduce the impact of volatile markets.
- Withdrawal Strategy: Implementing a flexible withdrawal strategy—such as the bucket strategy or reducing withdrawals in down years—can help manage the risk.
- Keep Cash Reserves: Having enough cash on hand to cover a few years of living expenses can prevent you from having to sell investments during a market downturn.
- Avoid Pro-Rata Withdrawals: Many investment managers and target date funds withdraw income pro rata from all investments. In a down market, this ensures the investments will be sold at a loss. Having a protection bucket to weather down markets can allow your stocks more time to recover, reducing the quicksand effect.
Conclusion
Sequence of return risk is a critical factor in retirement planning that shouldn’t be ignored. By understanding its potential impact and taking proactive steps to protect your savings, you can help ensure a more secure and sustainable retirement. Always consider working with a financial advisor to build a strategy that aligns with your long-term goals and reduces the risk of running out of money in retirement.
This blog post is for informational purposes only and should not be considered financial advice. The content provided is based on general principles and may not apply to your specific situation. Always consult with a qualified financial advisor before making any financial decisions.
