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As you approach retirement, one crucial concept to understand is the sequence of returns risk. This risk can significantly impact the longevity of your portfolio, especially when you start withdrawing funds to augment living expenses. The sequence of returns risk refers to the order in which investment returns occur and how they affect your financial plan. When you’re no longer working and you must rely on your savings, the timing of market gains and losses becomes critical.
Imagine you retire with a $1 million investment portfolio. If the market drops by 20% in your first year of retirement and you withdraw $100,000, your balance falls to $700,000. If the market drops another 10% the next year and you withdraw another $100,000, your balance plummets further. Recouping these losses now requires significant gains. Conversely, if your portfolio gains 20% in the first year, increasing to $1.2 million, and you withdraw $100,000, your financial situation remains positive and robust. The difference between these scenarios underscores the importance of managing withdrawals during market downturns.
If the market performs poorly at the start of your retirement, it can deplete your savings faster than expected. With retirement potentially lasting 20-30 years, and people living longer due to advancements in medicine, ensuring your portfolio’s longevity is essential.
Planning for sequence of returns risk involves understanding that market returns aren’t consistent and while a financial plan might assume an average annual return, actual returns will vary year by year. For example, if your portfolio experiences a negative return followed by positive returns, the timing of withdrawals becomes critical. A million-dollar portfolio losing 20% in the first year, combined with withdrawals, can severely limit future growth or recovery even if subsequent returns are positive.
Mitigating Sequence of Returns Risk
Diversification: Maintaining a well-diversified portfolio reduces volatility. Different asset classes perform differently under various market conditions. For example, while US equities might struggle, international or fixed-income investments could perform better, providing a buffer during downturns.
Seven-Year Backup Plan: As you near retirement, ensure you have seven years’ worth of expenses in safer investments. This strategy minimizes the need to sell assets at a loss during market downturns.
Roth Conversions: During market downturns, consider converting traditional IRA funds to Roth IRAs. This move leverages lower balances, reducing taxable income during conversion and allowing future growth to occur tax-free. Additionally, required minimum distributions could be a reason you are forced to take money out when the market is down. Roth IRAs don’t require mandatory distributions, offering flexibility in retirement.
Customized Planning: Generic advice, like a 60/40 portfolio split, does not suit every investor. Personalize your financial plan based on your specific situation. You may consider starting to scale back equity exposure and adjusting your investment strategy two to three years before retirement to mitigate risks.
Sequence of returns risk is a critical consideration for retirees, requiring thoughtful planning and strategy. Diversification, a seven-year backup plan, bucket strategies, and Roth conversions can help manage this risk. Begin preparing for retirement early, customizing your plan to ensure your assets last throughout your retirement. Consulting a financial advisor can provide personalized advice tailored to your needs, helping you navigate the complexities of retirement planning.
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Important Disclosures:
Securities and advisory services offered through EWA LLC dba Equilibrium Wealth Advisors (a SEC Registered Investment Advisor).
* Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
* Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity, and redemption features.
* The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. You cannot invest directly in this index.
* All indexes referenced are unmanaged. The volatility of indexes could be materially different from that of a client’s portfolio. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. You cannot invest directly in an index.
* The Dow Jones Global ex-U.S. Index covers approximately 95% of the market capitalization of the 45 developed and emerging countries included in the Index.
* The 10-year Treasury Note represents debt owed by the United States Treasury to the public. Since the U.S. Government is seen as a risk-free borrower, investors use the 10-year Treasury Note as a benchmark for the long-term bond market.
* Gold represents the afternoon gold price as reported by the London Bullion Market Association. The gold price is set twice daily by the London Gold Fixing Company at 10:30 and 15:00 and is expressed in U.S. dollars per fine troy ounce.
* The Bloomberg Commodity Index is designed to be a highly liquid and diversified benchmark for the commodity futures market. The Index is composed of futures contracts on 19 physical commodities and was launched on July 14, 1998.
* The DJ Equity All REIT Total Return Index measures the total return performance of the equity subcategory of the Real Estate Investment Trust (REIT) industry as calculated by Dow Jones.
* The Dow Jones Industrial Average (DJIA), commonly known as “The Dow,” is an index representing 30 stock of companies maintained and reviewed by the editors of The Wall Street Journal.
* The NASDAQ Composite is an unmanaged index of securities traded on the NASDAQ system.
* International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
* Yahoo! Finance is the source for any reference to the performance of an index between two specific periods.
* The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage is often obtainable in commodity trading and can work against you as well as for you. The use of leverage can lead to large losses as well as gains.
* Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
* Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
* Past performance does not guarantee future results. Investing involves risk, including loss of principal.
* The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee it is accurate or complete.
* There is no guarantee a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
* Asset allocation does not ensure a profit or protect against a loss.
* Consult your financial professional before making any investment decision.
In 15 minutes we can get to know you – your situation, goals and needs – then connect you with an advisor committed to helping you pursue true wealth.
EWA, LLC dba Equilibrium Wealth Advisors, is an SEC-registered investment advisory firm providing investment advisory and financial planning services to clients.
Investments in securities and insurance products are not insured by any state or federal agency.
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In 15 minutes we can get to know you – your situation, goals and needs – then connect you with an advisor committed to helping you pursue true wealth.