Imagine this: You've spent decades building your nest egg, carefully planning for a comfortable retirement. You've hit your magic number - that coveted $1+ million milestone.
You're feeling confident, ready to sail into your golden years. But what if I told you that the order in which your investment returns occur could make or break your retirement dreams?
Enter the world of sequence of return risk - a silent threat that could turn your well-laid retirement plans upside down.
It's not just about how much you've saved; it's about when your investments "decide" to perform well (or poorly).
This seemingly obscure concept can have a profound impact on your retirement success, potentially determining whether you'll be sipping margaritas on a beach or pinching pennies at home.
In this article, we'll dive deep into the waters of sequence of return risk, exploring its implications for your retirement journey. We'll unravel this complex concept, making it accessible and actionable for savvy investors like you.
By the end, you'll not only understand this crucial risk factor but also be equipped with strategies to navigate it successfully.
Before you keep reading, be sure to download our free retirement cheat sheets to potentially help you save money, reduce taxes, and optimize your portfolio for retirement.
Key Takeaways
Sequence of return risk refers to the potential impact of the order of investment returns on your retirement portfolio's longevity.
Negative returns early in retirement can significantly deplete your portfolio, making it difficult to recover.
Strategies to mitigate sequence risk include diversification, maintaining a cash buffer, and flexible withdrawal strategies.
Understanding and planning for sequence risk is crucial for those nearing or in early retirement.
Regular portfolio reviews and adjustments are essential to navigate sequence risk successfully.
What is Sequence of Return Risk?
Sequence of return risk, often simply called sequence risk, is a concept that's crucial for retirees and soon-to-be retirees to understand.
At its core, it refers to the risk that the order or sequence of investment returns could negatively impact a retiree's portfolio, potentially leading to its premature depletion.
The Mechanics of Sequence Risk
To truly grasp sequence risk, let's break it down with a simple example.
Meet Sarah and John, both 65 years old and ready to retire with $1.5 million each in their portfolios.
Sarah retires in a year when the market performs poorly, experiencing negative returns in the first few years of her retirement. John, on the other hand, retires when the market is booming, enjoying positive returns early on.
Even if both end up with the same average return over a 20-year period, Sarah could find herself in a much worse financial position due to sequence risk.
Why?
Because Sarah had to sell assets at lower prices to fund her retirement lifestyle during those early, poor-performing years. This leaves her with a smaller base from which to benefit when the market eventually recovers.
John, conversely, was able to leave more of his portfolio intact during those crucial early years, allowing it to grow more substantially over time.
The Critical Early Years
"The first five to ten years of retirement are crucial when it comes to sequence of return risk," says Scott Hurt, CFP®, CPA at Covenant Wealth Advisors in Richmond, VA.
"Negative returns during this period can have a disproportionate impact on your long-term financial security. It's not just about average returns; it's about when those returns occur."
This insight underscores why sequence risk is particularly relevant for those in or nearing retirement. Unlike younger investors who have time to ride out market volatility, retirees are actively withdrawing from their portfolios, making them more vulnerable to the timing of market downturns.
The Math Behind Sequence Risk
To truly appreciate the impact of sequence risk, let's delve into some numbers.
Consider two hypothetical retirees, Emily and Michael, both starting retirement with $1 million and planning to withdraw $40,000 annually (adjusted for inflation).
Scenario 1 (Emily):
Year 1: -20% return
Year 2: -10% return
Year 3: 0% return
Year 4: 10% return
Year 5: 20% return
Scenario 2 (Michael):
Year 1: 20% return
Year 2: 10% return
Year 3: 0% return
Year 4: -10% return
Year 5: -20% return
Despite having the same average return (0%) over five years, Emily's portfolio after five years would be worth approximately $710,000, while Michael's would be worth about $820,000.
This $110,000 difference is solely due to the sequence of returns!
The Compounding Effect
This difference becomes even more pronounced over time due to the power of compounding. With a smaller base to grow from, Emily's portfolio will struggle to keep pace with Michael's in the long run, even if future returns are identical.
Matt Brennan, CFP® at Covenant Wealth Advisors in Reston, VA, emphasizes this point:
"Sequence risk isn't just about the short-term impact. Its effects compound over time, potentially leading to a significant shortfall in your retirement funds. This is why it's crucial to have a strategy in place to mitigate this risk from the outset of retirement."
Real-World Implications of Sequence of Return Risk
Understanding sequence risk isn't just an academic exercise - it has real-world implications that can significantly impact your retirement lifestyle. Let's explore how this risk can manifest in everyday situations.
The Retirement Lifestyle Squeeze
Meet Robert and Lisa, a fictional couple in their late 60s who retired in early 2008, just before the financial crisis hit. They had diligently saved $1.5 million and planned to withdraw 4% annually ($60,000) to supplement their Social Security income.
However, as the market crashed, their portfolio value plummeted. By the end of 2008, their $1.5 million had shrunk to about $900,000. Suddenly, their $60,000 withdrawal represented nearly 7% of their portfolio - a rate that could quickly deplete their savings.
Robert and Lisa faced a difficult choice: maintain their planned lifestyle and risk running out of money, or significantly cut back on their retirement dreams.
This is the cruel reality of sequence risk - it can force retirees to make uncomfortable compromises at a time when they should be enjoying the fruits of their labor.
The Psychological Toll
Beyond the financial impact, sequence risk can take a severe psychological toll. Watching your hard-earned savings dwindle just as you enter retirement can be emotionally devastating.
It can lead to stress, anxiety, and a loss of confidence in your financial future.
For many retirees, this stress can manifest in overly conservative behavior, potentially missing out on market recoveries that could help replenish their portfolios.
It's a delicate balance between protecting what you have and allowing your money to continue growing throughout retirement.
The Ripple Effect on Family Dynamics
Sequence risk doesn't just affect the retiree; it can have ripple effects throughout the family. Adult children may find themselves unexpectedly supporting their parents financially.
Grandparents might not be able to help with grandchildren's education as they had hoped. Family vacations and other bonding experiences might be curtailed.
These changes can strain family relationships and alter the family dynamic in unexpected ways. It underscores the importance of not just financial planning, but also communication and setting realistic expectations with family members about the potential impacts of market volatility on retirement plans.
Strategies to Mitigate Sequence Risk
While sequence risk is a real threat to retirement security, there are several strategies that can help mitigate its impact. Here are some approaches to consider:
1. Build a Cash Buffer
One of the most effective ways to combat sequence risk is to maintain a substantial cash reserve. This "buffer" can be used to fund your retirement expenses during market downturns, allowing your invested assets time to recover.
Consider keeping 2-3 years of expenses in cash or cash equivalents. This strategy can help you avoid selling assets at depressed prices, preserving your portfolio's growth potential.
2. Implement a Bucket Strategy
The bucket strategy involves dividing your portfolio into different "buckets" based on when you'll need the money:
Short-term bucket: Cash and cash equivalents for immediate needs (1-2 years)
Medium-term bucket: Conservative investments for 3-10 years out
Long-term bucket: Growth-oriented investments for 10+ years in the future
This approach allows you to match your investments with your time horizon, potentially reducing the impact of short-term market volatility on your overall retirement plan.
3. Practice Flexible Withdrawals
Instead of sticking to a rigid withdrawal rate, consider adjusting your withdrawals based on market performance. In years of strong returns, you might take a little extra. In down years, you could tighten your belt a bit.
This flexibility can help preserve your portfolio during market downturns, increasing its longevity.
4. Diversify Your Income Sources
Don't rely solely on your investment portfolio for retirement income. Consider other sources such as:
Social Security
Pensions
Annuities
Rental income
Part-time work
A diverse income stream can reduce the pressure on your portfolio, especially during market downturns.
5. Maintain a Diversified Portfolio
While diversification doesn't eliminate sequence risk, it can help mitigate its impact. A well-diversified portfolio across various asset classes can potentially smooth out returns over time.
6. Consider a Rising Equity Glide Path
Traditionally, financial advisors have recommended decreasing equity exposure as you age.
However, to combat sequence risk, some experts suggest a "rising equity glide path" - starting retirement with a more conservative allocation and gradually increasing equity exposure over time.
I know this seems counter intuitive. But, this approach can help protect against early losses while allowing for growth potential in later years.
7. Regularly Review and Adjust Your Plan
Retirement planning isn't a "set it and forget it" endeavor.
Regularly review your portfolio and spending habits, making adjustments as needed. This ongoing management can help you stay on track despite market fluctuations.
Adam Smith, CFP® says,
"Don't wait for a market downturn to adjust your strategy. Regular portfolio reviews and proactive adjustments are key to navigating sequence of return risk successfully. It's about being prepared, not reactive."
The Role of Professional Guidance
Navigating sequence risk can be complex, and many retirees find value in working with a financial advisor. A professional can help you:
Develop a personalized retirement income strategy
Implement and manage a diversified portfolio
Adjust your plan in response to market conditions and life changes
Provide objective advice during turbulent times
Remember, the goal isn't just to survive retirement, but to thrive throughout your golden years.
Frequently Asked Questions
1. How does sequence risk differ from regular market risk?
Sequence risk specifically refers to the order in which investment returns occur, particularly in relation to withdrawals from a portfolio. While market risk affects all investors, sequence risk is especially pertinent to retirees who are actively withdrawing from their portfolios.
2. Can I completely eliminate sequence risk?
While it's impossible to completely eliminate sequence risk, you can significantly mitigate its impact through proper planning and investment strategies.
3. How does inflation factor into sequence risk?
Inflation can exacerbate sequence risk by necessitating larger withdrawals over time to maintain your purchasing power. This makes it even more crucial to have a strategy that accounts for both market volatility and inflation.
4. Is sequence risk only a concern in the early years of retirement?
While the early years of retirement are particularly crucial, sequence risk remains a factor throughout retirement. However, its impact tends to diminish over time as the retirement horizon shortens.
5. How often should I review my retirement plan to address sequence risk?
It's advisable to review your retirement plan at least annually, or more frequently during periods of significant market volatility or personal life changes.
Conclusion
Sequence of return risk is a critical concept that every retiree and soon-to-be retiree should understand and plan for.
While it presents a significant challenge, it's not an insurmountable one. By implementing strategies such as maintaining a cash buffer, practicing flexible withdrawals, and diversifying your portfolio and income sources, you can significantly mitigate the impact of sequence risk on your retirement.
Remember, retirement planning is not a one-time event but an ongoing process.
Regular reviews and adjustments are key to navigating the unpredictable waters of market returns and ensuring your retirement remains on track.
As you contemplate your own retirement journey, consider seeking professional guidance. A qualified financial advisor can help you develop a personalized strategy that accounts for sequence risk and aligns with your unique retirement goals and circumstances.
Need help planning your retirement? Contact us today for a free retirement assessment to see how we can help you.
Author: Megan Waters, CFP®
Megan Waters is a CERTIFIED FINANCIAL PLANNER™ professional and Financial Advisor at Covenant Wealth Advisors.
Megan has over 14 years of experience in the financial services industry. Raised in Williamsburg, VA, Megan graduated from the Honors College at the College of Charleston with a BS in Economics and a minor in Environmental Studies.
Disclosures: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond, Reston, and Williamsburg, VA. Registration of an investment advisor does not imply a certain level of skill or training. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. This article was written and edited by a CERTIFIED FINANCIAL PLANNER™ professional with the assistance of AI. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place. Hypothetical examples are fictitious and are only used to illustrate a specific point of view. Diversification does not guarantee against risk of loss. While this guide attempts to be as comprehensive as possible but no article can cover all aspects of retirement planning. Be sure to consult an advisor for comprehensive advice.
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