Can Your Retirement Portfolio Handle a Drop in the Market?
Imagine you’re five years out from retiring. Your assets are performing great, and you get excited because you will have enough money to retire and travel like you’ve always wanted to!
Then a major drop in the market happens, taking with it your hopes of traveling and a good chunk of your retirement money.
This is what sequence of return risk looks like for many retirees.
What is Sequence of Return Risk?
Sequence of return risk is the risk that an individual may experience negative investment returns early in retirement, which can significantly reduce the value of their retirement savings and potentially lead to a shortfall in retirement income. This can occur even if the average investment returns over the course of retirement are positive.
To illustrate the impact of sequence of return risk, consider two retirees who have the same average annual investment returns of 6% over a 20-year retirement. However, one retiree experiences a period of negative returns in the first few years of retirement, while the other retiree experiences negative returns in the last few years of retirement. The retiree who experiences negative returns early on will have a much lower retirement income than the other retiree, even though their average annual returns were the same.
Sequence of return risk is important because it can significantly impact a retiree’s financial security. If a retiree experiences negative returns early on, they may need to withdraw a larger percentage of their savings to maintain their desired standard of living, potentially depleting their savings too quickly. This can make it difficult to recover even if investment returns improve in later years. In contrast, if a retiree experiences negative returns later in retirement, they may have more time to recover from losses, as they will have already withdrawn funds from their portfolio.
There are several strategies that retirees can use to manage sequence of return risk, including:
- Diversify your portfolio: Diversification can help to mitigate the impact of poor investment returns in any single asset class.
- Consider a more conservative investment strategy: A more conservative investment strategy may provide more stability and reduce the risk of significant losses during market downturns especially as retirement gets closer.
- Implement a withdrawal strategy: Developing a withdrawal strategy that takes sequence of return risk into account can help to ensure that retirees don’t withdraw too much from their portfolio early in retirement.
- Use annuities: An annuity can provide a guaranteed stream of income, which can help to mitigate the impact of poor investment returns.
- Consider working longer: Delaying retirement or working part-time in retirement can provide additional income and allow retirees to delay drawing down their savings until market conditions are more favorable.