Sequence of Returns Risk: Understanding and Minimizing A Big Retirement Risk

Understanding Sequence of Returns Risk in Retirement: How to Protect Your Portfolio
‍

One of the biggest financial risks retirees face is known as sequence of returns risk. This risk involves experiencing a sharp drop in the stock market early in retirement, which can significantly impact the long-term success of your financial plan. Since retirees rely on their portfolios for income, withdrawals during a market downturn can have serious consequences. In this post, we'll explore sequence of returns risk, review insights from a JP Morgan Chase study, and discuss three effective strategies to mitigate this risk in your retirement plan.
‍

‍
‍

What is Sequence of Returns Risk?
‍

Sequence of returns risk is the risk that the market will decline sharply early in your retirement. When you're drawing income from your portfolio during a downturn, it can magnify the losses and potentially derail your financial security. Unlike when you're still working and contributing to your retirement savings, in retirement, you may not have the luxury of time to wait for the market to recover.
‍

Key Points to Understand:
‍

• The average long-term return of the stock market is approximately 10% per year, but returns vary greatly year-to-year.
• A significant market drop early in retirement, when you're making withdrawals, can compound losses and reduce the longevity of your portfolio.
• Sequence of returns risk isn't as concerning when you're 10 or more years away from retirement because you’re not yet drawing down from your portfolio, and historically, the market has had time to recover from short-term dips.
• However, during retirement, when you need income every month, this risk becomes much more serious.
  ‍

Visualizing Sequence of Returns Risk
‍

Let’s take a look at a study by JP Morgan Chase that illustrates this risk. The study examines three hypothetical retirees, each starting with a $1 million portfolio, planning for a 30-year retirement, and expecting an average return of 5% per year. Each retiree follows the 4% rule for withdrawals, adjusting annually for inflation.
‍

‍

Retiree A: The Perfect Scenario (Middle/Gray Line)
‍

• Scenario: Consistent 5% returns every year.
• Outcome: Retiree A ends up with $585,000 after 30 years.
• Reality Check: This scenario is highly unlikely, as markets don’t deliver consistent returns.
• Details: Retiree A’s portfolio remains relatively stable throughout the retirement period. The 4% withdrawals almost match the portfolio’s growth rate, resulting in a steady decline over time, leaving a decent nest egg even after 30 years.
  ‍

Retiree B: The Fortunate Investor (Top/Purple Line)
‍

• Scenario: Strong returns in the early years of retirement.
• Outcome: This retiree ends with almost $1.6 million, despite experiencing poor returns later in retirement.
• Why It Works: Positive early returns reduce the percentage of withdrawals relative to the growing portfolio.
• Details: In Retiree B’s case, the initial growth in the portfolio means that even when poor returns hit later, the portfolio is robust enough to weather the downturn. The early gains effectively shield the retiree from sequence of returns risk, allowing for a much larger ending balance.
  ‍

Retiree C: The Unlucky Investor (Bottom/Blue Line)
‍

• Scenario: Poor market performance right after retirement.
• Outcome: The portfolio runs out of money after just 22 years.
• Risk: Early losses combined with withdrawals prevent the portfolio from recovering.
• Details: Retiree C experiences a series of poor returns immediately after retiring, which, combined with regular withdrawals, drastically reduces the portfolio’s value. Without sufficient time for recovery, the portfolio is depleted well before the end of the 30-year retirement period.
  ‍

Conclusion: Retiree C's situation is the one you want to avoid. Below, we’ll explore three strategies to help protect your portfolio from this risk.
‍

How to Mitigate Sequence of Returns Risk
‍

To protect your retirement portfolio from sequence of returns risk, consider these three strategies:
‍

1. Use Annuities for Guaranteed Income
‍

Purchasing an annuity transfers the risk from the stock market to an insurance company, providing you with a guaranteed income for life. This strategy reduces your reliance on your investment portfolio during market downturns.
‍

• Benefits: Increases your spending floor with a guaranteed income.
• Application: Some retirees cover all fixed expenses (housing, groceries, utilities) with an annuity, leaving the rest of their portfolio invested for discretionary spending.
  ‍

When you buy an annuity with a portion of your portfolio, you're essentially ensuring that your basic needs will be met regardless of how the market performs. For example, by using the income from the annuity to cover your housing, groceries, and utilities, you reduce the strain on your portfolio, especially during market downturns.
‍

This strategy can be particularly effective when you combine it with Social Security, which can also be viewed as a form of annuity. By claiming Social Security earlier than initially planned, you can further reduce withdrawals from your investment portfolio. For instance, if you plan to retire at 62 but initially intend to claim Social Security at 67, consider claiming at 62 instead. This would reduce the amount you need to withdraw from your portfolio during those first five years, which can be crucial if the market performs poorly.
‍

Tip: Social Security is essentially an annuity. Claiming it earlier than planned can reduce withdrawals from your portfolio, thereby lowering sequence of returns risk.
‍

2. Implement the Bucket Strategy
‍

The bucket strategy involves dividing your portfolio into three "buckets" based on when you'll need the money:
‍

• Bucket 1: Immediate needs (0-2 years) in very safe assets like money markets and CDs.
• Bucket 2: Intermediate needs (3-5 years) in relatively safe assets like government and corporate bonds.
• Bucket 3: Long-term needs (7+ years) in stocks.
  ‍

How It Works: If the market drops, you withdraw from Bucket 1 first, allowing the other buckets time to recover. Historically, most bear markets don't last more than a few years, giving your stock investments time to rebound before you need them.
‍

The bucket strategy provides a way to segment your investments based on when you'll need them, allowing you to avoid selling stocks during a market downturn. For example, if the market drops, you can draw from Bucket 1, which contains safe, liquid assets like money markets and CDs. This allows your more volatile investments in Bucket 3 to remain untouched, giving them time to recover. If the market hasn't recovered by the time Bucket 1 is depleted, you can start drawing from Bucket 2, which contains relatively safe investments like bonds.
‍

The idea is to protect your stock investments from short-term market fluctuations by not relying on them for income until much later in your retirement. This way, your long-term investments have time to recover from any downturns, reducing the impact of sequence of returns risk.
‍

3. Adopt a Dynamic Spending Strategy
‍

A dynamic spending strategy involves adjusting your withdrawals based on market conditions, rather than sticking to a fixed percentage like the 4% rule.
‍

One popular method is the guardrails strategy:
‍

• Start with a 5% withdrawal rate.
• Increase or decrease withdrawals depending on how your portfolio performs.
  • Example: If your $1 million portfolio grows to $1.2 million, you might increase your income slightly. If it drops to $800,000, you reduce your withdrawals.
    ‍

Advantages: This approach allows for more flexibility, potentially letting you spend more in the early years of retirement without the risk of overspending. It also provides a clear plan for how to adjust your spending when the market fluctuates.
‍

The guardrails strategy is particularly appealing because it offers a more tailored approach to withdrawals, adjusting based on real-time portfolio performance. For instance, you might start your retirement withdrawing 5% of your portfolio, but if the market performs well and your portfolio grows, you could increase your withdrawals. Conversely, if the market drops and your portfolio decreases, you reduce your spending temporarily.
‍

What clients appreciate about this strategy is that it provides a clearly defined plan for what to do when the market fluctuates, reducing anxiety and uncertainty. By setting predefined rules for increasing or decreasing your withdrawals, you can maintain a sustainable income without the fear of running out of money too soon.
‍

Why It’s Effective: The guardrails strategy typically allows retirees to spend more money, especially in the early years of retirement, compared to the traditional 4% rule. It also helps minimize the regret of underspending, which can happen when retirees are overly cautious and end up with more money than they need later in life.
‍

Final Thoughts
‍

Understanding and planning for sequence of returns risk is crucial for a successful retirement. By considering strategies like annuities, the bucket approach, or dynamic spending, you can protect your portfolio from early market downturns and ensure a more secure retirement.
‍

If you weren’t familiar with sequence of returns risk before, hopefully, it’s on your radar now. For more insights into managing your retirement plan, including a deeper dive into the guardrails spending strategy, check out my other videos on YouTube.
‍

Thanks for reading, and I look forward to helping you retire with confidence and clarity!

‍