It’s not unusual to have a year in which the overall market is down at least 10%. It’s not even that unusual to have an actual bear market. As we like to say, time in the market is much more important than timing the market.
However, if a significant down market were to happen within a few years of retirement or early in retirement, the need to withdraw assets from a portfolio that is declining in value can have an outsized effect on the longevity of those retirement savings. This is what is known as the sequence of returns risk — that when certain returns happen matters more than that they happen.1
An example
Let’s look at two hypothetical investors entering their first year of retirement. Investor A and investor B each have $1 million saved for retirement. Each plans to withdraw $50,000 annually for retirement. However, the sequence of returns for each follows a different pattern.
| |
Investor A |
Annual Returns |
Investor B |
Annual Returns |
| Beginning Value |
$1,000,000 |
25% |
$1,000,000 |
-15% |
| Year 1 |
$1,200,000 |
22% |
$800,000 |
-20% |
| Year 2 |
$1,414,000 |
18% |
$590,000 |
15% |
| Year 3 |
$1,618,520 |
15% |
$628,500 |
5% |
| Year 4 |
$1,811,298 |
14% |
$609,925 |
8% |
| Year 5 |
$2,014,880 |
12% |
$608,719 |
12% |
| Year 6 |
$2,206,665 |
8% |
$631,765 |
14% |
| Year 7 |
$2,333,199 |
5% |
$670,212 |
15% |
| Year 8 |
$2,399,858 |
15% |
$720,744 |
18% |
| Year 9 |
$2,709,837 |
-20% |
$800,479 |
22% |
| Year 10 |
$2,117,870 |
-15% |
$926,583 |
25% |
| Ending Value |
$1,750,189 |
|
$1,108,229 |
|
Both investors experienced the same annual returns, but in reverse order during the 10 year period. The difference in the ending balances after those 10 years is striking, with the value of investor B’s portfolio in this example at about 63% of the value of investor A’s portfolio.
In the case of investor B, the significant losses they experienced in the first two years while also taking their annual withdrawals significantly reduced the value of their retirement nest egg. When certain returns happen matters more than that they happen.
Ways to minimize sequence of returns risk
Although you can’t predict or control how the stock market will perform, there are some steps investors nearing or in retirement can take to help minimize the sequence of returns risk.
Adopt a bucketing approach
Creating different “buckets” of retirement savings can often help you avoid withdrawing money from your portfolio when the market is declining.2
- Short-term needs: This bucket might be focused on spending needs for the next one or two years, holding short-term, very liquid investments like a money market fund or a high yield savings account. This would be the bucket from which you'd draw your annual spending needs in retirement.
- Intermediate needs: This bucket might be focused on spending needs for three to five years from now, holding moderate-risk investments like bonds, a CD ladder, or dividend-paying stocks. In the case of bonds or CDs, you would want maturities to line up with your projected needs.
- Long-term needs: This bucket is where you would keep investments geared for growth over the long term to help make sure that your retirement nest egg grows sufficiently, to minimize the risk that you’ll outlive your retirement assets.
Portfolio diversification
In addition to the need for separate retirement buckets, portfolio diversification is crucial, especially for the longer-term investment bucket. While you want to achieve enough growth to ensure that you don’t outlive your nest egg, proper diversification can help mitigate the impact of down markets on your portfolio.
This diversification can extend to the short-term and intermediate-term buckets as well. In addition to cash and income-producing assets, these buckets can include other assets that can be converted to cash if needed to support retirement spending needs, such as cash value life insurance, a cash-out home refinance, or luxury assets.
Plan ahead
An easy way to fall victim to the pitfalls of sequence of returns risk is to wait until your first year of retirement to begin dividing your retirement buckets. In the face of a significant down market, if you end up needing to take a withdrawal to cover your first year or two of retirement immediately, you could expose yourself to the full fury of sequence of returns risk.
If possible, try to start accumulating your first few years of retirement income prior to retiring. This can be done by selling off some holdings, all or in part, to raise cash. Another option might be to divert any mutual fund and ETF distributions to cash versus reinvesting them.
Manage retirement spending
While portfolio returns are an important component of the longevity of your retirement nest egg, the amount you withdraw from your retirement portfolio is also a key factor. Having a flexible spending budget that can expand or contract relative to the market can help you minimize withdrawals when the market is down.
If you’re facing a down market, another option is to work longer and delay retirement. These extra years in the workforce can potentially add to your Social Security benefits, and can serve to delay the need to take retirement income distributions.
Tax planning
Distributions from traditional IRAs and 401(k)s are taxed as ordinary income. If you have to withdraw extra cash to cover these taxes, this can accelerate the depletion of your nest egg, especially if you’re experiencing an early down market.
If possible, consider contributing to a Roth 401(k) or Roth IRA while working. You might also consider Roth conversions in the years leading up to retirement. The benefits of tax-free retirement income should of course be balanced against the tax impact of the conversions.
Maximize Social Security and pensions
Monthly payments from Social Security and/or a pension can help reduce the amount you need to withdraw from your accounts, helping to reduce the sequence of returns risk.
If you can wait to claim Social Security until age 70, you’ll receive the maximum initial benefit. If you’re married, it's important to coordinate the timing of benefits with your spouse to help maximize those benefits during your retirement, including survivors benefits.
If you’re covered by a workplace pension, the same logic applies. Be sure to review the options available as far as claiming a benefit.
QLACs
A QLAC (qualified longevity annuity contract) is a deferred annuity available to account holders of a 401(k), IRA or other qualified retirement account. A QLAC allows you to use up to $200,000 to purchase a deferred annuity, which can initiate distributions as late as age 85.3
The main benefit of a QLAC is that it allows you to defer some retirement income until later in retirement in the event that your retirement portfolio takes a hit, such as one arising from sequence of returns risk.
Conclusion
Markets will ebb and flow with periodic stock market downturns that occur every few years.4 Sequence of returns risk can be devastating for new retirees, if the down market is significant.
Taking steps to mitigate the potential impact of sequence of returns risk can help avoid this situation, and support a financially healthy retirement.
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