Retirement planning involves more than just saving; it also requires a strategy for managing withdrawals effectively. One of the key risks retirees face is sequence of returns risk, which refers to the impact of market fluctuations on withdrawals from investment accounts. Even if an investment portfolio averages strong long-term returns, the order in which gains and losses occur can significantly affect how long retirement savings last.
Understanding sequence of returns risk in retirement can help individuals make informed decisions about how to structure withdrawals, allocate assets, and plan for potential market downturns. This article explores how sequence risk works, why it matters, and strategies to help manage its impact.
What is Sequence of Returns Risk?
Sequence of returns risk occurs when the timing of investment gains and losses affects the sustainability of withdrawals in retirement. Market volatility during the early years of retirement can have a lasting impact on a portfolio’s longevity, particularly if an individual is withdrawing funds at the same time.
For example, two retirees with identical portfolios and average returns over 30 years may experience very different outcomes if one encounters significant market losses early in retirement while the other experiences strong early returns. The retiree who withdraws funds during a market downturn may have fewer assets left to benefit from future market recoveries, increasing the likelihood of depleting savings sooner.
This risk is particularly relevant for those who rely on investment portfolios for income, as market fluctuations can affect how much money remains for future years.
How Sequence of Returns Risk in Retirement Can Affect Income
Consider the following scenarios:
- Potential for Positive Market Performance Early in Retirement: If the market performs well in the early years of retirement, investment balances may have more time to grow before withdrawals significantly reduce the overall portfolio. This strategy could potentially contribute to the longevity of funds during retirement.
- Negative Market Performance Early in Retirement: If the market declines in the early years of retirement, withdrawals from a shrinking portfolio can compound losses, reducing the amount of assets available to recover during market rebounds. This can lead to a higher chance of running out of funds later in retirement.
Because no one can predict market performance with certainty, retirees must consider strategies that help manage this risk.
Strategies to Manage Sequence of Returns Risk
While sequence of returns risk cannot be eliminated, there are ways to structure a financial plan that may reduce its potential impact. Below are several approaches to consider:
- Diversifying Income Sources
Relying solely on an investment portfolio for income may increase exposure to sequence risk. Diversifying income sources can provide flexibility and reduce reliance on market-dependent withdrawals. Options include:
- Social Security benefits
- Pensions (if available)
- Annuities that provide structured payouts
- Cash reserves or short-term bonds for near-term expenses
By drawing from multiple income sources, individuals may reduce the need to sell investments at inopportune times.
- Implementing a Withdrawal Strategy
Choosing an appropriate withdrawal method can help manage sequence of returns risk. Common approaches you may have heard of include:
- The 4% Rule: This method involves withdrawing 4% of the initial portfolio balance annually, adjusting for inflation. While widely used in the past, it’s important to note that it is not necessarily the standard approach anymore. If you are considering this strategy, know that it may require modifications based on market conditions and individual needs.
- Dynamic Withdrawal Strategies: Adjusting withdrawals based on market performance can be a strategy to manage risk during downturns. This may involve reducing spending in poor market years or using a percentage-based withdrawal strategy.
- Bucket Strategies: This approach involves organizing assets into different “buckets” based on their purpose and how they contribute to a retirement income strategy. By allocating funds across various types of accounts and investments, individuals can create a structured withdrawal plan that helps manage risk and tax efficiency. Some buckets may focus on readily accessible funds, while others are designed for future income needs or long-term growth. This strategy allows retirees to draw from different sources based on market conditions, tax considerations, and evolving financial goals.
A well-structured withdrawal plan helps individuals navigate market fluctuations while balancing income needs.
- Annuities as a Potential Option for Stability
Annuities may provide a source of structured income that is not directly tied to market performance. Options such as fixed annuities or fixed index annuities can provide predictable payouts, helping to reduce reliance on investment withdrawals during market downturns.
- Reducing Portfolio Risk in Early Retirement
Adjusting asset allocation in the early years of retirement can help manage volatility. A more conservative allocation with a mix of equities and fixed-income investments may reduce exposure to market downturns while still allowing for long-term growth.
Some retirees gradually shift assets toward lower-risk investments as they begin withdrawing funds, while others maintain a balanced allocation throughout retirement. Finding the right approach depends on an individual’s goals, risk tolerance, and overall financial strategy.
The Importance of a Thoughtful Retirement Plan
Because market conditions are unpredictable, planning ahead for sequence of returns risk can help individuals manage their financial resources effectively. By incorporating diversified income sources, structured withdrawal strategies, and appropriate asset allocation, retirees can develop a plan that adapts to different economic conditions.
Consulting with a financial professional can provide insight into how sequence of returns risk applies to an individual’s unique situation and what steps may be taken to navigate market uncertainty while maintaining financial stability.
Are You Planning to Avoid Sequence of Returns Risk in Retirement?
Sequence of returns risk is an important consideration in retirement planning, as market fluctuations in the early years of retirement can significantly impact long-term financial outcomes. By understanding how this risk works and implementing strategies such as income diversification, structured withdrawals, and asset allocation adjustments, retirees can develop an approach that helps them manage market-related uncertainties.
Since no one can predict market performance, having a plan in place to address sequence risk is an important part of building a sustainable retirement strategy. By taking proactive steps today, individuals can better prepare for the financial realities of retirement.
If you’re interested in learning more about sequence of returns risk and how it may impact your retirement income plan, please reach out to schedule a complimentary strategy session today. We look forward to hearing from you!
