Sequence of Returns Risk – How to Avoid Disaster at the Start of Retirement

This is an educational and informational guide – it is NOT legal, tax, medical, or financial advice. Data may be outdated – always verify on the official site and with a licensed professional.

Sequence of returns risk refers to how poor investment performance in the early years of retirement can devastate your savings, even if average returns over the long term are positive. Understanding this risk is crucial for ensuring financial stability throughout your retirement.

What is Sequence of Returns Risk?

Sequence of returns risk is the risk that investments will perform poorly in the first years of retirement, which can lead to faster depletion of savings. Even if average annual returns are positive, negative results in the early years can significantly impact your finances. For example, if you experience losses in the first five years of retirement, it may force you to withdraw larger amounts from your account, which in turn leads to further reduction in the value of your savings.

How Does Sequence of Returns Risk Work?

Imagine you have 1 million dollars in retirement. If you lose 20% in the first year and gain 10% in the second year, your savings will be around 880,000 dollars. However, if you gain 10% in the first year and lose 20% in the second year, your savings will drop to about 800,000 dollars. Although the average return in both scenarios is the same, the financial outcome is significantly different. This illustrates how important the early years of retirement are.

What Are the Protective Strategies Against Sequence of Returns Risk?

Cash Buffer

A cash buffer is a strategy that involves keeping part of your savings in cash or a savings account. This gives you access to funds in case of market downturns, allowing you to avoid selling investments in unfavorable conditions. It is recommended to have 1 to 3 years' worth of expenses in cash as a buffer.

Bond Ladder

A bond ladder is an investment strategy that involves purchasing bonds with different maturities. This allows you to receive regular income from bonds that will mature at various times, providing flexibility in managing expenses. For example, if you have 1-, 3-, and 5-year bonds, you can access cash every year.

Dynamic Withdrawals

Dynamic withdrawals are an approach to withdrawing funds from a retirement account that adjusts the withdrawal amounts based on market performance. In years when the markets are strong, you can withdraw more, and in years when they are weak, less. This allows for better risk management and capital protection.

Common Mistakes with Sequence of Returns Risk

• Not considering sequence of returns risk in retirement planning.
• Keeping all savings in stocks without hedging.
• Not having a cash buffer for the early years of retirement.
• Withdrawing a fixed amount without considering market volatility.
• Lack of diversification in the investment portfolio.

What’s Next

1. Analyze your current retirement savings and understand how sequence of returns risk may affect them.
2. Consider creating a cash buffer or bond ladder to protect against market downturns.
3. Consult with a licensed financial advisor to tailor your withdrawal strategy to your needs.
4. Regularly monitor your investments and adjust your strategy as needed.

Sources

More information about sequence of returns risk and protective strategies can be found on sites such as AARP and Investopedia.