As you near retirement, securing your financial future becomes more critical. The years leading up to retirement, as well as the early years of retirement itself, are particularly vulnerable to market downturns, and it’s essential to take steps to protect your savings. Understanding risks like sequence of returns risk and having the right mix of investments can be the difference between a stable retirement and one plagued by financial uncertainty.

What Is Sequence of Returns Risk?

Sequence of returns risk refers to the impact that the order of investment returns has on your retirement savings, especially when you begin withdrawing funds. While it’s important to consider the average returns of your portfolio, what truly matters is how those returns unfold each year, particularly in the early stages of retirement.

If you’re close to retirement, this risk becomes more significant. For instance, if the market experiences a downturn during the first few years of your retirement, you may need to sell investments at a loss to cover your expenses. This can severely damage your portfolio’s long-term growth.

Why Timing Matters

As you approach retirement—usually within the last five years before you stop working—you enter what’s called the “retirement red zone.” During this time, the need for a stable portfolio becomes paramount. Any significant market downturn could seriously affect your ability to retire on time or at all. De-risking your portfolio in these final years is a smart move to safeguard your savings against unexpected losses.

Let’s consider two retirement portfolios with an initial value of $500,000. Both portfolios follow the same S&P 500 returns, but in reverse order:

• Portfolio 1 faces early losses followed by gains.
• Portfolio 2 experiences gains initially, followed by losses.

Despite identical average returns, the sequence of these returns causes dramatically different outcomes:

• Portfolio 1 loses more early on and, after 24 years, is nearly depleted, with just $27,000 remaining.
• Portfolio 2 benefits from early gains and ends up with over $2.8 million after 24 years.

This example shows how crucial it is to avoid withdrawing from your investments during a market downturn.

The Importance of Diversification

A well-diversified portfolio helps protect you from sequence of returns risk. By holding a variety of asset types—such as stocks, bonds, and real estate—you reduce the chances that a downturn in one sector will derail your entire portfolio. When some assets are losing value, others may be performing better, allowing your portfolio to recover without forcing you to sell at a loss.

For instance, if you need to sell assets to cover $50,000 in expenses but the stock market has fallen, a diversified portfolio might offer other, more stable options to draw from. Without diversification, a downturn could leave you with fewer options and a smaller portfolio.

Asset Allocation Strategies for Retirees

As you near retirement, you’ll face decisions about how to balance your investments. While stocks can offer higher long-term returns, they are volatile and can lose value quickly. On the other hand, bonds are typically more stable but offer lower returns.

Some retirees make the mistake of shifting entirely out of equities into conservative investments, which can leave them exposed to the risk of running out of money in later years. While a conservative strategy might seem appealing, it can prevent your portfolio from growing enough to sustain you through retirement.

A more balanced approach might include stocks that pay high dividends. These stocks can provide steady income while still offering growth potential. Additionally, companies with strong free cash flow are typically in a good position to weather economic challenges and continue paying dividends.

For those nearing retirement, some experts suggest a strategy called the “rising equity glide path.” This involves reducing stock allocation in the years leading up to retirement and then gradually increasing it as you age. This strategy helps protect against the risk of poor stock market performance early in retirement while still providing growth potential for the long term.

Deferred Income Annuities: A Safety Net

To further protect your retirement, consider a deferred income annuity (DIA). This annuity can offer a reliable source of income for the future. By purchasing a DIA, you can ensure that you have guaranteed income in retirement, regardless of market performance.

While DIAs are useful for ensuring stable income, they do come with some trade-offs, such as a lack of liquidity. It’s important to have other liquid assets available for emergencies. However, the peace of mind that comes with a guaranteed income stream can be invaluable for those concerned about outliving their savings.

A DIA can also help protect against retirement date risk—the possibility that you may not be able to retire when planned due to a market downturn. By purchasing a DIA that starts paying out when you retire, you guarantee yourself income even if the stock market doesn’t recover as expected. However, keep in mind that DIAs can be expensive, especially if you start the payments earlier.

Conclusion

Approaching retirement requires thoughtful planning and careful management of your investment portfolio. Protecting your savings from sequence of returns risk and market downturns can ensure you have the income you need in retirement. By diversifying your assets, adjusting your asset allocation, and considering a deferred income annuity, you can mitigate these risks and safeguard your financial future.