Retirement planning is a multifaceted endeavor that encompasses everything from asset allocation to health care costs.
One crucial — yet often overlooked — aspect is sequence of return risk. This risk refers to the danger of experiencing negative investment returns early in retirement, which can significantly deplete a retiree’s portfolio and potentially derail their long-term financial security.
What is sequence of return risk?
Sequence of return risk stems from the timing of investment returns rather than the average rate of return itself. It primarily affects retirees who depend on their investment portfolios for income. When the market experiences a downturn early in retirement, retirees face the double whammy of withdrawing funds from a shrinking portfolio while simultaneously experiencing losses.
Even if the market rebounds in subsequent years, the initial depletion of assets can have lasting repercussions on the sustainability of retirement funds.
The impact of sequence of return risk
The ramifications of sequence of return risk can be profound. A study by the American College of Financial Services found retirees who experience poor market performance in the early years of retirement face a significantly higher risk of running out of money later. This risk is particularly pronounced for those who follow a fixed withdrawal strategy, as they must sell assets at depressed prices to meet their income needs.
Moreover, sequence of return risk can force retirees to adjust their lifestyle or spending habits unexpectedly. This can lead to emotional stress and anxiety, undermining the enjoyment of retirement years that should ideally be characterized by peace of mind and financial security.
Mitigating sequence of return risk
While sequence of return risk cannot be eliminated, there are several strategies retirees can use to mitigate its impact:
Asset allocation. A well-diversified portfolio that includes a mix of stocks, bonds and other assets can help cushion the impact of market downturns. Bonds, in particular, provide stability and can serve as a source of income during bear markets.
Dynamic withdrawal strategies. Instead of adhering to a fixed withdrawal rate for their income plan, retirees can adopt dynamic withdrawal strategies that adjust their spending based on market performance. Techniques, such as the Guyton-Klinger rules or the 4% rule with guardrails, allow retirees to scale back withdrawals during poor market conditions, preserving their portfolio for future years.
Cash reserves. Maintaining a cash reserve equivalent to one to two years’ worth of living expenses can provide a buffer during market downturns. This enables retirees to refrain from selling investments at unfavorable prices and gives their portfolios time to recover.
Longevity planning. Incorporating longevity risk into retirement planning can help retirees prepare for the possibility of a longer-than-expected lifespan. Annuities and other longevity products offer guaranteed income streams that can supplement retirement savings and reduce reliance on volatile investment markets.
Regular portfolio rebalancing. Periodic rebalancing ensures that a portfolio’s asset allocation remains aligned with the retiree’s risk tolerance and financial goals. This practice prevents overexposure to volatile asset classes and reduces the impact of market fluctuations.
Conclusion
Sequence of return risk poses a significant threat to retirees’ financial security, especially in an era of increasing market volatility and uncertainty. However, by understanding the nature of this risk and implementing prudent mitigation strategies, retirees can safeguard their retirement income and enjoy a more stable and fulfilling post-work life.
As with any aspect of retirement planning, consulting with a qualified financial adviser is essential when looking to tailor strategies to individual circumstances and goals. By taking proactive steps to address sequence of return risk, retirees can enhance their resilience in the face of market turbulence and achieve greater peace of mind.
Dan Dunkin contributed to this article.
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