Have you ever been forced to sell investments in a down market? If so, then you know it’s not a great feeling — and it’s probably something you’d like to avoid in the future.
Taking withdrawals during a market downturn can have a lasting impact on the longevity of your nest egg — especially if that downturn occurs early in your retirement. This is why preparing for sequence of returns risk, or sequence risk, should be a critical part of your retirement plan.
Why does the sequence of your returns matter?
There’s no predictable pattern for when the market will go up or down — and a bear market could happen when you least expect it. Sometimes, you might even experience negative returns for a whole year or for multiple years in a row.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
If you’ve just started your retirement and you’re making systematic withdrawals during that time, there’s a chance you could shrink your portfolio to the point that you can no longer maintain your planned retirement lifestyle. (Remember, you won’t be making contributions anymore, so you won’t be able to build back your balance the way you could when you were still working.)
The reason this retirement bogeyman is called sequence of returns risk is because it’s about the order in which your returns occur — and it is, for the most part, a matter of good or bad timing. If you retire just before or after a bull market, your account may grow enough so you can more easily deal with a downturn later on. But if you retire in a bear market, your balance may never recover.
Here’s a basic example of how the sequence of returns could affect two retirees quite differently — even if they experience the same overall rate of return, start with the same amount of money ($500,000) and withdraw the same amount ($20,000) every year for five years.
Investor A gets lucky and starts his retirement during a bull market. His returns look like this:
- Year 1: +26.67%
- Year 2: +19.53%
- Year 3: -10.14%
- Year 4: -13.04%
- Year 5: -23.37%
Even with a huge loss in year five, because of his early success, Investor A finished the five years with $378,376.
Investor B is not so fortunate. She takes her long-planned retirement just as a painful bear market begins. Her returns come in the exact opposite order of Investor A’s:
- Year 1: -23.37%
- Year 2: -13.04%
- Year 3: -10.14%
- Year 4: +19.53%
- Year 5: +26.67%
Investor B ends up with $326,831. That may not seem like a big difference, but it’s $51,545 less than Investor A has left working for him — after just five years.
What can you do to prepare for sequence of returns risk?
The less time you have to make up for investment losses, the more important it is to protect your principal.
By the time you reach retirement, you may have read or heard the previous sentence so often that you’ll start tuning it out. But it’s something that everyone who expects to take regular withdrawals from their portfolios should keep in mind.
As you make a plan to safeguard your retirement income, here are some strategies to consider:
1. Know your sustainable withdrawal rate.
This is the estimated percentage of your savings you expect to be able to withdraw each year in retirement without running out of money. Don’t just assume it’s 4%. That was an old rule of thumb, but it may not work for you. There are formulas and online calculators that can give you an idea of what a safe withdrawal rate might be. But I suggest working with a retirement specialist — someone who understands your needs and goals — when designing your individual income and investment plan.
2. Think about using a retirement bucket strategy.
With a bucket strategy, you can be sure you’ll have the money you need in the short term while you continue growing money for later in retirement. You can tailor this strategy to suit your specific needs, but here’s how it generally works:
- Bucket No. 1, the short-term bucket, usually holds enough cash and cash equivalents (on top of your Social Security benefits and pension income) to cover your costs for three years. Having this money set aside at the start of your retirement could help you avoid having to sell stocks at a loss if a market downturn should occur.
- Bucket No. 2, the intermediate-term bucket, typically holds some type of low-risk or guaranteed income investment to replenish the short-term bucket. Some options might include fixed annuities or multi-year guaranteed annuities (MYGAs), CDs or short-term high-quality bonds held to a laddered maturity. (In my opinion, long-term bond funds are not a suitable solution for the principal-protected portion of your portfolio. There are many investments available that provide better stability these days.)
- Bucket No. 3, the long-term bucket, usually holds higher-risk investments (such as stocks) to provide the growth you’ll need as a hedge against inflation and longevity risk later in retirement.
3. Don’t put off retirement planning.
If you’ve been DIYing your portfolio for years, or if you’re working with a financial professional who isn’t retirement-focused, you may have to make serious adjustments to transition from accumulation to preservation.
Some of these changes can take time, so don’t wait until you’re a few months or even a couple of years away from your planned retirement date. In the best-case scenario, you should start to shift your mindset and your money 10 years out — but five years ahead of time is a minimum.
Kim Franke-Folstad contributed to this article.
The appearances in Kiplinger were obtained through a public relations program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
Related Content
- Five Tax Moves Retirees Should Consider Before Dec. 31
- Nervously Nearing Retirement? Four Do’s, Four Don’ts and One Never
- Five Reasons You’ll Blow Up Your Retirement Plan
- To Create a Happy Retirement, Start With the Three Ps
- Five Common Retirement Mistakes and How to Avoid Them
-
The ‘First Year of Retirement’ RuleThe 'first year of retirement' rule says the 12 months after you leave work set the tone for your entire later life — so it's vital to approach them mindfully.
-
Tech Stocks Drag This Growth Fund DownA rough stretch for mega-cap tech and tech-adjacent names has put pressure on this Mairs & Powers mutual fund.
-
Timing Is Everything for Roth Conversions: An Expert's Guide to the Right StrategyUnderstanding the nuances of Roth conversions can help you avoid forking over more money in taxes than you need to.
-
Are You Ready for the Emotional Side of Retirement?Financial adviser warns that life after work is coming, so start preparing … mentally, as well as financially. If you're nervous, take heart. Some simple strategies could ease the way.
-
Four Ways to Help Prevent a Market Downturn From Scrambling Your Nest EggYou may not be able to avoid a market decline when you're newly retired and starting to rely on your nest egg for income, but you can plan for that risk.
-
Is Your Home Disaster-Ready? An Insurance Expert's Guide to Preparing for Storms and FiresHomeowners can take these steps to protect their properties from hurricanes, tornadoes, wildfires and hail, while also potentially reducing their insurance costs.
-
A Financial Adviser's Defense of Annuities: They're Just MisunderstoodAnnuities can offer retirement income stability and security against market volatility, though some do have drawbacks. The key is to understand their features before buying.
-
Diversification: An Investment Adviser's Guide to Why You Need It and How to Achieve ItHow confident are you that your money will go the distance? Building a balanced portfolio can shore up your investments' long-term stability.
-
How My Dad Taught Me the Compounding Returns of FatherhoodAs Father's Day approaches, I remember how my father's small acts of love and generosity added up over time and influenced my relationships with my own children, proving that the best investments can grow across generations.
-
Financial Professional's Key to Peace of Mind in Retirement: Income PlanningCreating guaranteed income sources in retirement will help you truly enjoy your golden years and spend less time worrying about money.
