Clearly, there is a lot to think about when planning for retirement. While investors have a degree of control over many of the choices involved, there’s one big wild card called “sequence-of-returns risk,” and it’s important to plan ahead in order to be as prepared for it as possible.
What is sequence-of-returns risk?
Sequence-of-returns risk is the risk of encountering market downturns in early retirement. This is an important consideration, because the random sequence in which you earn your returns early in retirement can have a significant impact on your lasting wealth. Simply put, a retirement portfolio that happens to experience positive returns early in retirement will outlast an identical portfolio that must endure negative returns early in retirement, even if their long-term rates of return end up the same.
As we all know, global stock markets are volatile. While long-term average annual returns may be in the range of 7% net of inflation, markets rarely deliver this exact average any given year. Soaring one year, plummeting the next; we never know for sure how far above or below average each year will be.
During your working life this doesn’t matter so much because you’re mostly spending earned income while adding to your retirement reserves as aggressively as your plans call for. As long as you stay the course—benefiting from the upswings and enduring the downturns—tolerating market volatility is just part of the plan. In fact, when you’re still accumulating wealth, market downturns give you the opportunity to buy more shares than you otherwise could when prices are higher. When the market recovers, you then have more shares to recover with, which ultimately strengthens your portfolio.
But then, you stop working and start spending your reserves, adding withdrawal risk to the mix. This has an opposite effect from that experienced during the accumulation phase. Now, when stock markets decline, you may need to sell shares at lower prices to generate income, which means you’ll have to sell more of them to withdraw the same amount of cash. Even though the market is expected to eventually recover and continue upward, your portfolio will have fewer shares with which to participate in the recovery. This hurts your portfolio’s staying power. Because of this type of withdrawal risk, it won’t be able to bounce back as readily as when you were adding shares to it, or at least not taking them away.
How can investors plan for sequence-of-return risk?
Since nobody can predict which return sequence they’ll experience early in their retirement, what can you do to prepare?
First, sequence-of-return risk should not change your overall approach to investing. As recent years (and even recent months) have clearly shown us, you never know what’s going to happen next. Downturns usually occur without warning, while some of the strongest rebounds begin amidst the darkest days.
So, whatever your age or how long until your retirement, we still recommend building and maintaining a low-cost, globally diversified portfolio that reflects your personal goals and risk tolerances. We still advise against trying to pick individual stocks or react to current market conditions. We still suggest you only change your portfolio’s asset allocations if your personal goals have changed—never in emotional reaction to changeable market moods.
Here are some “income-smoothing” tips for mitigating sequence risk after you retire.
1. Keep working. If you are willing and able, you might postpone retirement or even return to the workforce part-time. Any earned income can reduce the amount of assets you must sell in down markets to maintain your lifestyle. If your circumstances allow, you may be able to not only avoid spending retirement reserves during down markets, but even add more in (buying at bargain prices).
2. Spend less. Were you planning for higher investment returns than reality has delivered? Since your portfolio is most vulnerable to negative sequence risks early in retirement, you may want to initially spend less than planned, to give your portfolio the fuel it needs to replenish itself.
3. Tap other assets. When you retire, you typically have several sources of income to draw from. You may have traditional investment accounts, retirement accounts, Social Security, or pension plans. Your investments are usually divided between stocks and bonds. You may have equity in your home. You may have an annuity. You may have cash reserves. If you encounter negative market returns early in retirement, you might be able to tap a combination of your non-stock assets for initial spending needs. This can mitigate the hit your portfolio will otherwise have to take if you must liquidate shares of stock.
4. Consult with a financial advisor. Sequence risk is usually not the only consideration at play in retirement planning. There are taxes to consider, estate plans to bear in mind, carefully structured investment portfolios to maintain, and logistics to learn. All this speaks to the value an experienced advisor can add before, during, and after this pivotal time in your financial journey.
At Mathis Wealth Management, we know that many different factors can affect your retirement income strategy. By helping clients plan ahead, we can help them reduce the risks posed by market volatility during the early years of retirement. Let us help you create a solid strategy for retirement.
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Disclosure: All investing involves risk and there is no guarantee that any investment strategy will be successful. Diversification is an investment strategy that can help manage risk within a portfolio, but it does not guarantee profits or protect against loss in declining markets.
This is meant for educational purposes only. Information presented should not be considered investment advice or a recommendation to take a particular course of action. Always consult with a financial professional regarding your personal situation before making any financial decisions.
