What is Sequence of Return Risk?
Sequence of return risk pertains to income planning during retirement and the timing of making withdrawals from your investments. The more you rely on your investments to meet your current income needs, the more market downturns can significantly impact your portfolio and lifetime income strategy. This is because a crucial element of investing is giving your money time to grow in the market and not being forced to sell investments at an inopportune time.
It is a lot like gardening. When you plant a seed, you do not expect to harvest fruit the next day. It takes time, patience, and care to grow. Over time, that plant will begin to bear fruit. However, if you pick the fruit too early, you miss out on its full potential, and your harvest will be much smaller than had you waited.
Why is Sequence of Return Risk Important?
Like a well-tended garden produces a bountiful harvest, a well-managed investment strategy can yield significant returns over time, ensuring you have enough to sustain yourself during your retirement years.
As you withdraw from your investments during retirement, the idea is that the growth of your portfolio will replenish (or at least a portion of) what you take out. Well-planned withdrawals, coupled with investment growth, make your retirement income strategy sustainable over the length of your well-earned retirement.
However, a predominant risk is that a significant drop in the value of your investments in the early years of retirement will complicate your strategy. When you withdraw from your portfolio as it is decreasing in value, without proper planning, it may force you to sell more investments than you had planned to in order to raise enough cash to meet your current income needs. Doing so drains your savings more quickly by locking in losses and leaves you with fewer assets that can generate growth when the market recovers. Moreover, this risk can affect the longevity of your retirement portfolio and increase the chances of outliving your money.
Factors that Influence Sequence of Return Risk
Several factors contribute to your sequence of return risk. The first risk, and one you have the least control over, is market volatility. The longer you invest, the more ups and downs you will experience. That unpredictability is the price of admission to reaping the rewards of growth for your money. These fluctuations can be dramatic over a short period. During retirement, if you are forced to sell some of your investments to cover the cost of living expenses, you realize those losses, thus reducing the amount of money available to grow during a market recovery. Prolonged losses can compound, making it even more challenging for your portfolio to sustain withdrawals.
The timing and length of your retirement can also greatly influence your exposure to sequence of return risk. The first few years of retirement can be critical as a period of negative returns early on can have a lasting impact on your financial security. If you decide to retire just before or during a market downturn, the withdrawals you initially take may come at a time when your portfolio is getting smaller. Conversely, if you retire during a bull market, you take those initial withdrawals as your portfolio increases. Unfortunately, not everyone gets to choose when they retire. You may get forced out by your employer and be at a stage in life that is too late to find a similar position with a comparable income. Additionally, with the advancements in medicine, individuals are living longer, thereby extending the length of time they need to make their money last.
To illustrate the difference a market downturn can make at the beginning of retirement versus further into retirement, the chart below shows the portfolio balance trajectory of two investors. Both of these hypothetical investors had a starting balance of $1 million, took an initial withdrawal of $50,000, and increased their withdrawals at 2% annually to account for inflation. Investor 1 experiences a 15% decline for the first two years and a 6% return for years 3-18. Investor 2's portfolio assumes a 6% return for the first nine years of retirement, then experiences the same 15% decline in years 10 and 11 and a 6% return for years 12-18. As you can see, a significant market decline early in retirement can have long-lasting effects on your long-term financial security.
Source: Schwab Center for Financial Research
Another critical factor is your withdrawal rate, the annual percentage of the funds you distribute from your investments, and taxes. A higher rate increases the likelihood of depleting your savings, especially during market downturns. On the other hand, being flexible with your withdrawal rate by potentially reducing it increases the probability of your money lasting your lifetime and can help with stress brought on by declines in the market. Withdrawing 4% of your portfolio annually is a commonly used rule of thumb for a safe withdrawal rate, but it highly depends on your circumstances. Having a tax-smart withdrawal strategy is also important. If you are taking distributions from a pre-tax (traditional) retirement account, that amount is subject to taxation at your ordinary income tax rate. That taxation eats into the net amount you receive but also increases what you need to take out to receive the money required to meet your expenses while also having to pay Uncle Sam his fair share. Being informed and having a tax planning strategy to limit your tax hit on distributions is essential to help ensure your money lasts through retirement.
The chart below expands on what would happen with the two investors from the graph above. Both Investor 1 and 2 experience a 15% decline in years one and two, while both hypothetical investors also withdraw $50,000 per year. Starting in year three, both portfolios grow 6% per year. However, Investor 1 opts for a 2% annual withdrawal rate, while Investor 2 takes out 4% yearly.
Source: Schwab Center for Financial Research
Strategies to Mitigate Sequence of Return Risk
Managing sequence of return risk is essential to safeguarding your retirement. Without a carefully considered investment and retirement plan in place, even the most well-intended strategies can be vulnerable to fluctuations in the market. Fortunately, there are actionable things that can help you get through the inevitable ups and downs of the market. These will enable you to worry less about the market and focus more on enjoying your retirement. Here are some examples of things you can do to help make your money last:
Retirement bucket strategy. When you look at your portfolio, it is easy to think of it as a whole and to focus on the investment return of that whole. However, financial professionals separate your retirement assets into three 'buckets' – short-term, intermediate-term, and long-term.
Short-term investments are usually cash and cash equivalent investments. It may not grow as much as the rest of your portfolio, but it allows you to quickly access your money when needed, and it helps further cushion your portfolio against market fluctuations.
Intermediate-term investments are typically your allocation to bonds. These are generally less risky than stocks and help balance your portfolio by providing steady income and protecting against the volatility of stocks.
Long-term investments are the allocation to stocks in your portfolio. While stocks have their ups and downs in the short term, they have historically offered the highest potential for growth over time.
Diversification. Build a portfolio with a mix of stocks, bonds, and cash that weathers market volatility before and in retirement, matches your risk tolerance, and aligns with your goals.
Income-generating investments. Incorporating income-generating investments into your portfolios, such as bonds and dividend-paying stocks, can provide a steady income stream and reduce the need to sell other assets during a market downturn.
Flexible withdrawal strategies. A fixed withdrawal rate, like the 4% rule we discussed earlier, is a good starting point, but it may not be ideal for all market conditions. Instead, consider adopting a flexible strategy that adjusts your withdrawals depending on market conditions. This dynamic retirement-spending strategy, also called a 'guardrails' strategy, can effectively boost your cash flow if done properly.
Maximizing Your Social Security Benefits. The longer you delay claiming Social Security benefits (up to age 70), the higher your guaranteed income later in retirement. This helps reduce your reliance on withdrawing from your investments to meet your current income needs and takes the pressure off trying to maximize returns and, therefore, potentially taking on more risk than is prudent. The additional income from delaying benefits can act as a safety net, providing more financial security as you age.
Eliminate as much debt as possible heading into retirement. Entering retirement with minimal or no debt can significantly reduce financial stress and improve your cash flow. By prioritizing paying off debts (especially high-interest debts), you free up more of your income for essential expenses. This means you will need to withdraw less from your investments, allowing them to grow. A debt-free retirement can give you peace of mind and enable you to enjoy your retirement without the burden of worrying about making monthly payments.
Bottom Line
Understanding and managing sequence of return risk is essential for preserving your retirement savings and ensuring you can enjoy those years without overwhelming financial stress. By adopting strategies like reducing or eliminating debt, diversifying your investments, utilizing flexible withdrawals, and incorporating income-generating assets, you can enhance your portfolio's longevity and reduce your sequence of return risk.
Retirement planning is more than just about building a nest egg; it is about crafting a sustainable income stream that empowers you to live the life you always envisioned. With proper planning and a proactive approach, you can confidently navigate the various twists and turns of retirement, focusing on what truly matters: enjoying every moment to the fullest. If you still need to do so, take the time to review your retirement strategy with a financial advisor who can help you chart your course toward financial freedom.
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About the Author
Holzberg Wealth Management is a family-owned and operated financial planning and investment management firm based in Marin County, CA. As your financial advisors, we serve you as a fiduciary and are fee-only, so we never receive commissions of any kind. We help individuals and families like you in the greater San Francisco Bay Area and virtually nationwide with the financial decision-making process to organize, grow, and protect your assets.
** This writing is for informational purposes only. The author and Holzberg Wealth Management do not guarantee or otherwise promise any results that may be obtained from using this report. No reader should make any investment decision without first consulting their financial advisor and conducting their own research and due diligence. These commentaries, analyses, opinions, and recommendations represent the personal and subjective views of the author and do not constitute a recommendation, offer, or solicitation to make any securities transaction. The information provided in this report is obtained from sources that the author believes to be reliable. External links to third parties are being provided for informational purposes only. Holzberg Wealth Management is not affiliated with the third-party websites linked to, unless otherwise explicitly stated, and does not constitute an endorsement or approval by Holzberg Wealth Management of any of the third party’s products, services, or opinions. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Any charts and graphs provided are hypothetical and for illustrative purposes only, are not indicative of any investment, and assume reinvestment of income and no transaction costs or taxes.