You followed all of the rules: Start saving early. Don’t touch it; just let compound interest do its thing. Diversify your portfolio.
Now you are primed for the retirement you’ve always dreamed of. Lake-side fishing and kayaking all on your watch, plus all the home updates you had been denying yourself in order to save.
Now the biggest threat is one you probably never even heard of: Sequence of returns risk. What is it and how can you guard your investments against it?
Defining Sequence of Returns Risk
Would you be surprised to learn that the timing of market returns in retirement is just as important—if not more important—than the rate of return itself?
Sequence of returns risk, or just sequence risk, is all about timing. If the market is up when you retire, then your withdrawals for income could be offset by new gains. But if it’s a bear market, your withdrawals lower the balance without being offset at all. Withdrawing on a down portfolio can shrink the balance of your portfolio quicker than you imagined.
Early Losses Are Harder to Recuperate
At this point, you may be thinking, “Sure, but what if I earn higher returns later? Won’t I at least break even?†Even higher returns later in retirement make it near impossible to make up for early loss. Why? Because the return it takes to recuperate loss is exponentially higher than the rate of loss. For example, a 10% loss isn’t recuperated with a 10% gain. A 10% loss is recuperated with an 11.11% gain. A 15% loss takes 17.65% to recover. And an 80% loss takes 400% to recover!
To demonstrate sequence risk, let’s look at . Two retirees each start with $1 million and withdraw $60,000 each year for four years. Retiree A’s account has annual returns of -30%, 5%, 12%, and 25%. Retiree B’s account has returns of the exact opposite: 25%, 12%, 5% and -30%. What do their account balances look like after four years?
â— Retiree A: $720,000
â— Retiree B: $831,768
At the end of four years, Retiree B has $111,768 more all because of the order, or sequence, of the returns earned early in retirement, even though both had the same drawn down plan and rates of return.
5 Ways to Guard Against Sequence Risk
To help you mitigate the sequence of returns risk for your portfolio, consider the following tips:
1. Keep some cold, hard cash
Having a portion of your assets in cash and cash equivalents equal to about 1-2 years of retirement withdrawals can give you lots of flexibility. If the market is in a downturn, you can ride it out without taking any distributions.
2. Safer allocations (Maybe)
Retirement isn’t the time to jump on the . You should understand exactly how much risk you are taking with your investments to be sure it is appropriate for your income needs and your comfort level.
3. Keep Working
Even though this solution is not ideal, by staying in your job, you give (1) the market time to correct (2) yourself more time to save and contribute to your retirement accounts and (3) more time for your social security to accumulate.
4. Limit withdrawals
If your retirement is already in the works and you can’t put it off until the market recovers, then try to limit your withdrawals or lower your withdrawal rate.
5. Reduce spending
This is everyone’s go-to whenever there is a bear market regardless of retirement plans or not. While you could take a big step and downsize your house, for example, simply choosing a cheaper vacation or cutting down on discretionary spending could be enough to keep your income on track.
Just because you don’t have control over where the market will be when you retire, doesn’t mean you don’t have any control over what happens to your nest egg. Sequence of returns risk is something to be aware of so that you can enjoy it and have even more peace of mind!
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