Imagine retirement is on the horizon. You have saved for years and invested in a mix of stocks and bonds. You’ve garnered a healthy return. And though you often cringed when the market nosedived, you stood firm and resisted the temptation to panic.
Now you want to retire, but you’re wondering what are the risks? One to consider is sequence risk (also known as sequence of returns risk). That’s the risk your portfolio will suffer low or negative returns in the early years of retirement—right when you’re beginning to withdraw funds from your nest egg.
Let's illustrate sequence risk by using the following scenarios.
Jill and John each set aside $500,000 in tax-advantaged retirement accounts. For the sake of this example, assume all assets are invested in mutual funds tracking the Standard and Poor’s 500 index and each person withdraws 4% annually.
John retires first, in January 2008. Over the next 12 months the S&P 500 index drops over 38%. By the end of his first retirement year, John’s portfolio has dwindled to $290,000. Five years later, his retirement account balance has recovered to only $390,000.
Jill has the good fortune to retire later, in January 2013. Because of a booming stock market, her portfolio grows to more than $750,000 subsequently.
- Withdraw your least volatile assets first. Sequence risk tends to have less impact on safe and predictable investments like U.S. Treasury bonds and high-rated corporate bonds. Other more volatile investments—stocks and real estate, for example—tend to be hit harder during economic downturns. They also tend to pay higher returns and provide inflation protection over the long term. If possible, leave your more unpredictable accounts intact until later.
- Re-balancing is key. Every year look at your retirement portfolio and re-balance your investments according to your age, financial situation and willingness to take risk. While you cannot predict when large downturns occur, when they do, your sequence risk is somewhat reduced.
- Keep tabs on your withdrawal rate. If possible, leaving more money in retirement accounts can help keep sequence risk at bay. This strategy only works if you have alternative sources of income. Options for increasing income and lowering withdrawal rates might include working part-time or taking Social Security benefits earlier than planned.
- Continue to diversify. As the life expectancy of older Americans continues to climb, retirement savings must often last 30 years or more. Inflation, though historically low, can be expected to whittle away at retirement portfolios over those decades. So it’s important to keep a portion of your savings in investments that have a good probability of outpacing inflation over the long term.
Even if sequence risk hammers your portfolio in the early years of retirement, take time to do your homework. Refuse to give in to panic. And, above all, ask for help! Hopefully you will be enjoying retirement for a long time.