Sequence of Return Risk: A Retirement Game Changer Near Retirement

Sequence of return risk, often underestimated, is a critical concept for anyone approaching or in retirement. It highlights that the order in which investment returns occur can significantly impact the longevity of retirement savings, often more so than the average return itself. This is especially pronounced as retirement nears and during the initial years of retirement withdrawals.

To understand sequence risk, consider two hypothetical retirees, both starting retirement with identical portfolios and aiming for the same annual withdrawal rate. Let’s assume both experience the same average annual return over their retirement period, say 7%. However, their experiences diverge based on the sequence of these returns.

Retiree A is fortunate. In their early retirement years, they experience strong positive returns. Even while making withdrawals, their portfolio balance grows substantially due to these early gains. This positive sequence creates a powerful buffer. The portfolio is bolstered early, making it more resilient to potential market downturns later in retirement. The early growth reduces the proportional impact of subsequent withdrawals and allows the portfolio to benefit more from compounding over time.

Retiree B, unfortunately, faces the opposite. They encounter negative or lackluster returns in the initial years of retirement, just as they begin making withdrawals. This negative sequence is detrimental. Withdrawals made during market downturns force them to sell assets at lower prices, effectively locking in losses and depleting the principal faster. This “negative compounding” effect can severely erode the portfolio’s ability to recover, even if the market eventually rebounds. While the average return over the entire retirement period might be the same as Retiree A, Retiree B is at a much higher risk of running out of money prematurely due to the unfavorable sequence of returns early on.

The impact is magnified near retirement because this is when two critical factors converge: portfolio balances are typically at their highest, and withdrawals are commencing or imminent. A significant market downturn just before or in the early years of retirement can be devastating. Imagine a substantial market correction coinciding with your first few years of withdrawals. The combination of market losses and ongoing withdrawals creates a double whammy, shrinking the portfolio rapidly and making it significantly harder to recover. The time horizon for recovery is also shorter in retirement; there are fewer working years left to replenish savings.

Furthermore, the psychological impact of negative sequence risk can be profound. Witnessing a portfolio diminish rapidly in early retirement can induce panic and potentially lead to poor investment decisions, such as selling low in fear of further losses, further exacerbating the situation.

Mitigating sequence of return risk requires proactive planning. One key strategy is to adjust asset allocation as retirement approaches. This often involves gradually shifting towards a more conservative allocation, reducing exposure to volatile assets like equities and increasing holdings in less volatile assets such as bonds or cash equivalents. This shift aims to protect capital during the critical early retirement years. However, it’s a balancing act, as overly conservative allocations might hinder long-term growth needed to combat inflation and maintain purchasing power throughout a potentially long retirement.

Another approach is to consider flexible withdrawal strategies. Instead of fixed withdrawals, retirees might consider variable withdrawals that adjust based on portfolio performance or market conditions. In years with poor returns, withdrawals could be reduced, and in years with strong returns, they could potentially be increased. This flexibility helps to preserve capital during downturns and extend portfolio longevity.

Finally, incorporating guaranteed income sources, such as Social Security, pensions, or potentially annuities, can provide a safety net against sequence risk. These guaranteed income streams can cover essential expenses, reducing the reliance on portfolio withdrawals, particularly during periods of market volatility.

In conclusion, sequence of return risk is a powerful force that can significantly impact retirement outcomes, especially in the years surrounding retirement. Understanding this risk and implementing appropriate mitigation strategies are crucial components of robust retirement planning for advanced investors seeking to secure their financial future. Ignoring sequence risk can lead to a significantly diminished retirement experience, even with seemingly adequate savings and reasonable average returns.