Investing for retirement means factoring in different types of risk that may affect your portfolio over time. Sequence of returns risk, also referred to as sequence risk, can come into play as you begin taking withdrawals from your retirement accounts. Specifically, it’s the possibility that the timing of your retirement withdrawals may negatively impact your overall rate of return. Knowing how to account for sequence risk in your financial strategy can help minimize the threat it may pose to your retirement income. Be sure to use the experience and insights of a financial advisor as plan for and investing during your retirement.
Sequence Risk, Definition
There are two general phases to retirement planning: the accumulation phase and the withdrawal phase. During the accumulation phase, you’re saving and investing to build wealth. For example, you may be contributing money to your 401(k) or a similar retirement plan at work while also funding an individual retirement account. And you might be supplementing that with investments in a taxable brokerage account.
When you retire, you enter the withdrawal phase in which you begin relying on the money you’ve saved and invested for income. This is where you begin taking 401(k) or IRA withdrawals or selling off investments in your taxable account.
Sequence of returns is a risk that stems from the order that investment returns occur. Specifically, it’s the risk that the market will experience a downturn resulting in lower returns at the same time you enter the withdrawal phase. Sequence risk is important to be aware of because it can directly impact how long your retirement savings lasts.
Sequence Risk Example
To understand how sequence risk works, it’s helpful to have an example. So, say you have two investors who each retire at age 65 with $1 million saved. Both investors follow a 5% rule for annual withdrawals and earn an average annual return of 6%. But Investor A retires when the market is up while Investor B retires during a market downcycle. In the first three years of retirement, their respective returns look like this:
Returns at age 66
Investor A: 5%
Investor B: -25%
Returns at age 67
Investor A: 28%
Investor B: -14%
Returns at age 68
Investor A: 22%
Investor B: -10%
So how much does sequence of returns risk hurt Investor B?
Assuming those returns, at age 66 Investor A’s portfolio would still be worth $1 million while Investor B’s would be worth $700,000 thanks to the -25% return. At 67, Investor A would have $1,230,000 while Investor B would have $552,000.
This trend continues, even as the market improves and Investor B earns higher returns over time. It ends with them finally running out of money for retirement at age 82. Investor A, however, reaches age 90 with just over $2.5 million in retirement savings.
This sequence risk example illustrates just how important timing can be when planning for retirement. While both investors grew their initial nest eggs to $1 million, they were affected differently by the timing of the market cycle. If you’re worried about longevity and having enough money to last in retirement, then it’s important to plan ahead for how sequence risk of returns might affect you.
How to Minimize Sequence of Returns Risk
The movements of the market are not something an individual investor can control. There’s no way to predict whether the market will be up or down when you’re ready to retire. And in some cases, you may be forced into early retirement because of an illness, injury or layoff. But it is possible to plan ahead for sequence risk and potentially minimize the impact it may have on your retirement wealth.
First, you can base your retirement withdrawal calculations on the assumption that you’ll be entering retirement in a down market. The 4% rule has long been the rule of thumb for retirement withdrawals but you may need to adjust that to account for the possibility of lower returns. Creating a sample retirement budget can help you estimate what your annual expenses might be and how much you’ll need to withdraw.
Next, consider when you plan to retire. The typical retirement age is 65 or 66 but if you’re concerned about sequence of returns risk affecting your portfolio’s longevity, then you might choose to continue working longer. This can delay the need for retirement withdrawals for a few years. You can also benefit from delaying Social Security, as doing so can increase your monthly benefits.
Working longer means you can continue contributing to your 401(k), so you can accumulate more savings for retirement. If you have a Roth IRA, you can also make contributions to it as long as you’re working. A Roth IRA can also be preferable for managing sequence risk for a different reason since unlike a traditional IRA, you’re not required to take minimum distributions starting at age 72.
Diversifying your portfolio can also offer some protection against sequence of returns risk. Investing in fixed income securities, such as bonds, alongside stocks, exchange-traded funds or mutual funds can help you create a portfolio that’s well-rounded. Shifting some of your assets to cash could also make sense, though that won’t shield you from reductions in purchasing power caused by inflation. You can also introduce other hedges against market volatility and inflation, such as real estate investments or Treasury inflation protected securities.
Talking to your financial advisor can help with coming up with additional strategies for downplaying the effects of sequence risk in your portfolio. For example, your advisor may suggest something like an annuity to produce guaranteed income in retirement which could help to offset negative returns if the market dips. They can also help with planning ahead for long-term care costs, which could take a sizable bite out of your retirement income.
The Bottom Line
Sequence of returns risk is the risk that the market will experience a downturn resulting in lower returns at the same time you retire and begin withdrawing accumulated assets. It can detract from your efforts to save and invest money for the future, increasing the possibility of running out of money once you retire. It may not be possible to entirely avoid sequence risk when preparing for retirement. But by thinking ahead, you can insulate your portfolio from it as much as possible.
Tips for Retirement Planning
Consider talking to a financial advisor about what sequence risk could mean for your retirement outlook. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area. It takes just a few minutes to get your personalized advisor recommendations online. If you’re ready then get started now.
Make sure you run the appropriate numbers through a retirement calculator to confirm your estimates of what you’ll need after you stop earning money and how much you can safely withdraw from accumulated funds.
Aside from annuities, life insurance is something else you might consider for mitigating sequence risk. A permanent life insurance policy that builds cash value that you can borrow against could be used as an additional income stream in retirement. Just keep in mind that withdrawing money from a cash value life insurance policy can reduce the death benefit that’s paid out to your beneficiaries once you pass away.
Photo credit: ©iStock.com/FG Trade, ©iStock.com/PIKSEL, ©iStock.com/flyzone