Help Protect Retirement Income: Understand Sequence-of-Returns Risk
Volatility in the markets can quickly upend your sense of financial well-being—and undermine the theory that a well-funded retirement portfolio will provide a lifetime of steady income. If you’re nearing or in retirement and are worried about how you’ll make your portfolio last in uncertain times, make sure you understand sequence-of-returns risk. Taking this little-known risk into consideration could help preserve some of your portfolio’s value and help your bottom line recover more quickly.
Weathering a downturn in retirement
Sequence-of-returns risk refers to the possibility that you’ll have to withdraw funds at the same time that your portfolio is losing value. Because you have to sell more shares to get the same amount of cash, you’re left you with fewer shares to compound in the future. “That’s like dollar-cost averaging backwards,” says Rob Williams, vice president of financial planning at the Schwab Center for Financial Research. “If you sell when prices are down, you further deplete your portfolio.”
Then, when the market bounces back, your shrunken portfolio won’t fully benefit from the gains because you’ve sold so many shares. If the decline is steep or lasts awhile, that could make it even harder to recover. How can you help minimize this lost ground? Consider reducing your withdrawal rate.
In the chart above, Bill and John each retire with a well-diversified portfolio of $1.2 million and decide to follow the popular 4% withdrawal rule. If their assets grow at 6% per year and they spend 4% in the first year of retirement—in this case $48,000—and then adjust that figure annually for inflation, their assets could last 30 years.
Unfortunately, the market falls 10% in the first year and 10% the following year. Having stuck to their withdrawal plan, they both enter their third year of retirement with a balance just under $890,000.
A rebounding market would quickly make up lost ground, right? Unfortunately, no—those continuing withdrawals are a strong headwind. But by dialing back his withdrawals to 2% Bill would cut his recovery time to just eight years. John, on the other hand, would need 16 consecutive years of 6% annual gains to get back to where he started.
“Bucketing” to reduce sequence-of-returns risk
To reduce your exposure to the sequence-of-returns risk, move some of your assets into low-risk, low-volatility investments like bonds and cash investments. Be sure to leave the bulk of your funds invested more aggressively, however. Why? Moving all your money into low-risk, low-volatility investments could mean abandoning growth potential and possibly winding up in a worse predicament.
Rob recommends keeping a year’s worth of expenses in cash, and another three to five years’ worth in assets that can be easily liquidated (for example, high-quality, short-term bonds and cash), if you can. With these protective measures in place, you might feel comfortable taking on more risk with the rest of your portfolio.
Build flexibility into your plan
If the market continues to trend downward, try scaling back a planned withdrawal even further or even skipping it. You could also forgo inflation adjustments or postpone large expenses. These steps may not have a noticeable impact on your day-to-day comfort level but, compounded, they can help keep your portfolio robust. If you can avoid a major sale of higher-risk investments in a down market—especially early in retirement—all the better.