Down markets can rattle even the most seasoned investors, but for retirees or those approaching retirement, market volatility during this risk window can be the difference between running out of money and having a legacy to leave behind. Why? Because early losses in retirement can permanently damage your ability to generate income for the rest of your life. This risk is called the sequence of returns risk, and if you’re preparing for retirement, it’s one of the most important concepts that you need to understand.
In this article, we’ll explore what sequence of returns risk is, why it matters, and four proven strategies recommended by retirement income expert, Dr. Wade Pfau to protect your nest egg.
What is Sequence of Returns Risk?
Sequence of returns risk refers to the danger of receiving poor returns in the 5 years leading up to retirement through the first 5 years of retirement. Negative returns that wipe out years of saving and growing your nest egg if wiped out during this period of time will almost guarantee running out of money too soon. Even if your average return over 30 years is solid, the order of the returns matters a lot.
This is compounded if you suffer losses during this window and take withdrawals to cover expenses. This essentially locks in those losses, further reducing growth potential of your remaining assets.
4 Strategies to Reduce Sequence of Returns Risk
- Spend Conservatively. Spending less might not sound fun, but small adjustments can go a long way, especially in early retirement. One smart move, delay claiming Social Security benefits until age 70 to create a bridge to cover income needs in the meantime. For example, using Treasury Inflation Protected Securities (TIPS) in a bond ladder structure can provide reliable, inflation adjusted income during the early years of retirement. This helps to avoid drawing down the account when the market is down.
- Adopt a flexible spending strategy. The traditional 4% rule assumes you withdraw a fixed amount each year, adjusted for inflation. But markets aren’t predictable, and neither should your withdrawal strategy be. Instead, spend more when markets perform well, and tighten your belt when the market is down. This avoids selling investments when prices are low.
- Reduce portfolio volatility. Reducing volatility can help you avoid steep declines in portfolio value, especially in early retirement. Once approach is the rising equity glide path. Start retirement with a lower equity allocation (say, 30-40%) and gradually increase the allocation to equities over time.
- Use a buffer asset. When markets are down, using a non-correlated buffer asset can help you avoid selling investments at a loss. According to Wade Pfau, “as long as the buffer assets cost less than the amount it protects, it’s worth it.” Buffer assets may include:
- Cash reserves
- Reverse mortgage line of credit
- Cash value life insurance
Why You Need a Retirment Income Plan
If you’re within 5 to 10 years of retirement, now is the time to build a retirement income strategy that accounts for sequence of returns risk. Every retiree’s situation is different, and the right solution may include a mix of the strategies above.
Sequence of returns risk is real, but it doesn’t have to derail your nest egg if you have a plan. With the right combination of conservative withdrawals, flexible spending, reduced volatility and buffer assets, you can create a plan that weathers markets ups and downs.
References:
Retirement Researcher- Wade Pfau
Social Security Administration-Delayed Retirement Credits
Investopedia-Cash Value Life Insurance
HUD-Home Equity Conversion Mortgage
Ready to talk? Contact Brightside Financial to schedule a no-obligation consultation. Let’s protect your retirement income and give you the confidence to enjoy your golden years.
