Retirement planning is more than just saving money; it’s about managing the risks that could impact your ability to enjoy a stable financial future. One of the most overlooked risks is “sequence of returns” risk. While many focus on the returns themselves, the order in which these returns occur can be just as important, especially for those relying on their investments for retirement income.

What is Sequence of Returns Risk?

Sequence of returns risk refers to the potential negative impact that the order of investment returns can have on a retirement portfolio, especially during the early years of retirement. When you begin withdrawing money from your investments, the timing of market downturns can make a huge difference in how long your savings last. A couple of years of poor returns early on in retirement can significantly damage your portfolio, even if the overall long-term returns are positive.

Understanding the Impact: A Hypothetical Example

Let’s take a look at two individuals—Mary and Bob—to demonstrate how sequence of returns risk works.

In the first scenario, both Mary and Bob experience the same average annual return of 4.23% over 10 years. However, the timing of their returns is different. Mary faces negative returns in the last two years of her 10-year period, whereas Bob faces those same negative returns in the first two years. Despite having the same returns and ending up with the same amount of money ($1,578,100), their experiences are very different.

Now, let’s assume both individuals retire and begin withdrawing $50,000 per year from their $1,000,000 portfolios. While both still experience the same 4.23% annual returns, the results are drastically different due to the timing of the market losses.

Mary, who experiences negative returns later in her retirement, ends up with a balance of over $1.1 million after 10 years. Meanwhile, Bob, who faces losses in the early years of retirement, has only about $500,000 left. The difference in their outcomes is due to the sequence of returns, with Bob’s withdrawals occurring during a time of market decline, preventing his portfolio from recovering.

The Importance of Timing

As these examples illustrate, the order of returns can be just as important as the amount of return. Retirees who begin drawing from their portfolios during a market downturn are at a higher risk of depleting their savings prematurely. In these cases, the market recovery may not be enough to make up for the early losses.

Strategies to Mitigate Sequence of Returns Risk

While sequence of returns risk is a significant factor in retirement planning, there are several strategies that can help mitigate its impact:

1. Guaranteed Income Products: Some retirees use income annuities to guarantee that essential expenses are covered, regardless of market fluctuations. This strategy ensures that even if markets decline, basic needs are met without tapping into the volatile portion of the portfolio.
2. Buffer Strategy: Another approach is to keep a portion of retirement savings in safe, low-risk assets that are specifically designated for the first few years of retirement. This can provide a “buffer” that ensures income for the early retirement years, when markets may be down.
3. Flexible Spending Plan: Some retirees adopt a flexible spending approach, where they plan to reduce their spending during periods of market downturns. This allows them to conserve their portfolio until market conditions improve.

Each of these strategies comes with its own advantages and challenges. A flexible approach may work well for some, while others may prefer the peace of mind that guaranteed income products provide.

Conclusion

Sequence of returns risk is an often-overlooked factor in retirement planning, but understanding its impact is crucial for ensuring a sustainable retirement income. By diversifying income sources, using guaranteed income strategies, or creating buffers to protect against market declines, retirees can better prepare for the challenges posed by market volatility. Consulting a financial professional can provide valuable insight into which strategies are best suited to your unique retirement goals.