As investors approach retirement, it is crucial for them to be aware of the potential threat known as “sequence of returns risk.” This risk, also referred to as “sequence risk,” is a significant issue caused by poor investment returns combined with withdrawals, especially in the early years of retirement. This unfortunate combination can lead to a gradual reduction in the retirement nest egg over time, potentially jeopardizing financial stability in the future. According to certified financial planner Collin Lyon, the investment returns and timing of withdrawals during the early retirement years can have a profound impact on the next three decades of retirement.
For individuals reaching retirement age, the ability to withdraw funds from retirement accounts without penalty typically begins at age 59 1/2. However, there is a substantial risk for those who are either in retirement or on the brink of retirement if they face stock market downturns just before or during the initial stages of tapping into their accounts. Selling assets during a market decline could result in a scenario where more assets need to be liquidated to obtain the same amount of cash, leaving fewer investments available to capitalize on future market growth. This situation poses a considerable challenge for younger retirees who need to cover living expenses for several decades using their retirement savings.
Strategies to Minimize Sequence of Returns Risk
Financial advisors suggest various methods to mitigate the impact of sequence of returns risk on retirees’ portfolios. As retirement approaches, it is advisable to adjust portfolio allocations by shifting from high-risk assets to more stable investments like bonds. The appropriate mix of assets depends on factors such as risk tolerance, financial goals, and life expectancy. Diversifying investments among multiple asset classes can help reduce the impact of market volatility, as recommended by Collin Lyon.
To shield your portfolio from the negative effects of sequence risk, financial experts recommend maintaining a six-month emergency fund and a reserve fund to cover living expenses. Wealth advisor Jonathan Bednar II suggests having a “war chest” comprised of fixed-income assets equal to five years of expenses, such as bonds or certificates of deposit. This strategy provides retirees with the ability to withstand market fluctuations during periods of high sequence risk. Implementing flexible withdrawal strategies based on market performance is another effective way to safeguard your retirement savings. Adjusting withdrawal rates during years of market downturns can help preserve the core of your portfolio, ensuring long-term financial stability.
Sequence of returns risk poses a significant threat to retirees’ financial security and should not be overlooked. By being proactive and adopting strategies like diversifying investments, maintaining emergency funds, and adjusting withdrawal rates, investors can mitigate the negative impact of sequence risk on their retirement portfolios. It is essential for individuals approaching retirement to work closely with financial advisors to develop personalized strategies that address sequence of returns risk and ensure a stable financial future throughout their retirement years.