Understanding sequence risk and its impact on your retirement savings

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Withdrawing from an investment account during a down market.

© cjansuebsri, Yeti Studio, amstockphoto, New Africa, Cressida/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

Imagine you’ve scrimped and saved for decades to build a decent nest egg. You’re ready to retire and know how much you can withdraw from your retirement account each year. But then stocks take a dive. You retire into a bear market, and at the end of a couple of rough years, you’re not sure your investments will support you for the rest of your lifetime.

Grim as this scenario may be, it illustrates sequence of returns risk, also known as sequence risk. When you have to take money out of the market while it’s down, it drains your capital more than if your investments were logging gains. That reduces the positive impact of compounding returns on your future portfolio growth. Sequence risk can take a toll on your retirement savings, but there are ways to manage and reduce its impact.

Sequence of returns risk has to do with timing. It’s the concept that when you withdraw money from your retirement account matters. Once you retire, chances are, you’ll begin to withdraw funds from your retirement account. And if you do that during a bear market, depending on how far the market has fallen, you may find that your gains have been erased and you’re dipping into your principal.

Compare that to retiring in a bull market. Even though you withdraw money from your retirement portfolio to pay for retirement expenses, your investment gains will likely offset the withdrawals—and might even provide you with growth.

Let’s say you plan to build a $1 million retirement portfolio using stocks and assume performance based on the S&P 500. You decide on an annual withdrawal rate of 5% ($50,000 a year).

Dollar cost averaging and starting early help you build your nest egg because the trend line smooths out over long periods. Annualized returns for the S&P 500 historically average close to 10%, and buying in a down market lets you capture bigger gains during an up market.

But once you start taking money out of the market to pay for retirement, things change. If you have to pull retirement money out of your nest egg when the market is in a down cycle, it hurts more than you might expect because your portfolio is losing value at the same time you’re withdrawing capital.

There’s no way to eliminate sequence of returns risk, but you can reduce its impact on your ability to retire and limit how much it damages your overall portfolio.

You can use various strategies to mitigate sequence risk so you don’t have to return to the workforce to rebuild your depleted retirement savings.

1. Rebalance your portfolio. Consider rebalancing your portfolio to reduce exposure to equities, which can sometimes be more volatile. For example, if your portfolio has 75% stocks and 25% bonds, consider adjusting so your allocation is 60% stocks, 30% bonds, and 10% alternative investments (“alts”). High-quality bonds can produce income and help offset losses. Alternative investments might enhance growth relative to overall portfolio risk, especially if you select investments with low historical correlation to stocks and bonds.

2. Reduce your withdrawal rate. Rather than withdrawing at a 5% rate, you might pinch pennies and drop to a 4% rate during a down year. Using the negative sequence of returns example above, if you dropped to a 4% withdrawal rate or reduced your expenses by $10,000 a year, you’d still have $706,623 after two years. That gives you a little more capital to build on later.

3. Increase your income and contribute to your nest egg during retirement. Another way to reduce sequence risk is to work during retirement. You can augment your savings by taking a part-time job or diversifying your income with additional revenue sources.

If your work and diverse income sources earn you $30,000 annually, for example, you could reduce your withdrawal rate to 2% during down markets. Using the same example from above, you’d have $744,014 in your portfolio at the end of two years, because you’ve reduced how much you had to dip into capital.

You don’t have to wait until you retire to start planning for sequence of returns risk. Here are some things you can do before your retirement date to begin bolstering your finances:

Sequence risk can’t be eliminated unless you avoid the financial markets altogether. But by saving early, investing consistently, and reducing how much you must withdraw during a bear market, you can decrease the risk of outliving your nest egg.

And even if you do find that your retirement account balance has fallen as a result of a market tumble, you can reduce the impact and get your retirement plan back on track.