What Is the Sequence-of-Return Risk and How Can Retirees Mitigate Its Effects?

January 23, 2023
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With the possibility of a recession looming, it's natural for those nearing or in retirement to have concerns over their long-term strategies. After decades of accumulating a portfolio, the last thing retirees want is for a market downturn to force them to consider lifestyle changes.

It’s helpful for retirees and soon-to-be retirees to understand sequence-of-return risk and how it can impact their retirement. Below is an explanation of sequence-of-return risk and a few approaches to help manage its effects.

What Is Sequence-of-Return Risk?

Sequence-of-return risk refers to the idea that the timing of poor investment returns can significantly impact the longevity of your savings. For someone just retiring, the earlier your portfolio experiences a market downturn, the more vulnerable you are to the so-called sequence-of-returns risk. 

Understanding the “Fragile Decade”

The "fragile decade" refers to the five years before and five years after a person enters retirement. It is a transition period as a person shifts from accumulating wealth to living on savings and investments. The decisions a retiree makes during this decade will play a role in determining the lifestyle choices available to them throughout the remainder of their retirement.

How to Manage Sequence-of-Return Risk

Here are a few ideas to help retirees entering or nearing retirement manage sequence-of-return risk amidst market volatility.

Pad Your Reserves

Drawing down too much of your portfolio early in retirement can reduce its ability to generate income over time. To help mitigate this risk, retirees nearing the “fragile decade” may want to start building some short-term reserves.

Like preparing for a hurricane, those approaching retirement should be collecting and storing "supplies" to help them weather the storm. These reserves can help cover expenses early in retirement without requiring withdrawals from investments.

How much should retirees set aside for this purpose?

There's no one-size-fits-all answer. Some investors are comfortable with approximately one year's expenses, whereas some would like a larger cushion. But keep in mind that maintaining a short-term reserve has advantages and disadvantages. A licensed financial professional has tools that may help you determine how much to keep in reserve based on your goals, time horizon, and risk tolerance.

Manage Your Withdrawals

Some see withdrawals as a set amount over a period of time, whereas others anticipate managing withdrawals based on market conditions.

A financial professional can help determine which approach may work best for you. Also, some may be able to reduce or skip withdrawals based on market conditions. But others may not see that as a choice. With the guidance of a financial professional, investors can determine what fits their lifestyle.  

Consider Income Laddering

Laddering different types of retirement income is one approach that may help manage sequence-of-return risk. 

Here's how it works: A retiree buys fixed-income securities with different maturity dates so that they can quickly respond to changes in interest rates. A bond ladder helps manage reinvestment risk because the retiree owns a portfolio of fixed-income investments with varying maturities, allowing for reinvestment at prevailing market rates. 

Gradually Transition into Retirement

No hard and fast rule says to stop working during retirement. On the contrary, many retirees find it beneficial to ease their way into full retirement. In 2018, 9.1 million people reported still working either a full-time or part-time job past age 65. For context, this is a 60% increase in later-in-life workers than reported just a decade earlier.1  

Although many have initially prepared to stop working altogether, there are financial and personal benefits to maintaining a part-time job or encore career.

Regarding sequence risk, continuing to work during a market downturn may allow you to manage the amount withdrawn from your investments.

Some employers offer healthcare plans for eligible workers, including part-time employees. For retirees who are not yet eligible for Medicare, this could be an effective way to manage healthcare expenses during the early years of retirement.

Money aside, a more gradual retirement transition can help reduce the risk of social isolation and loneliness and give retirees a sense of purpose and mental stimulation. 

Be Flexible and Thoughtful with Your Spending

You've likely spent years, decades even, preparing for retirement. So, the idea of “being flexible” may initially not make sense. But the markets are unpredictable, so managing your wealth can require adjustments and adaptability to new circumstances.

During the fragile decade, take the time to consider what your "must haves" are and what you can feasibly live without. Would you do it if taking a minor hit to your retirement lifestyle for a short period could help protect your retirement income?

It could be time to consider downsizing from a large family home to something a little more manageable or adjusting your entertainment budget to include fewer nights out. It may be helpful to prioritize your spending. Listing out expenses in order or importance can help you discern between what’s non-negotiable and what's nice to have.

Delay Social Security Benefits

If you can address your retirement income needs without drawing down your investments, you may also want to consider delaying your Social Security benefits. The longer you wait to receive these benefits, the more per month you may receive.

Individuals are eligible to begin receiving Social Security benefits at age 62. However, you'll receive a reduced amount if you take benefits before your full retirement age. For example, if you were born in 1954 and were set to receive $1,000 per month in Social Security benefits at full retirement age, that amount would be reduced to $750 if you started receiving it at age 62. The deductions range from 25% to 30%, depending on your full retirement age.2  

On the other hand, you may be able to increase your Social Security benefits by taking advantage of delayed retirement credits. For every month you wait to start receiving Social Security after reaching full retirement age, you'll receive an additional delayed retirement credit to your benefits (up until age 70). In general, you will see an extra 8% added to your benefits every year you wait.3  

Preserving Your Income in Retirement

No one wants a down market to impact their retirement. Preparing for various scenarios is an important aspect of an overall financial strategy. Our firm works with clients to help them outline their unique scenarios and develop an approach to maximize their retirement income. 

If you or someone you know is approaching retirement and might benefit from a discussion regarding the sequence-of-return risk, we'd welcome the opportunity to meet. Many of our clients are those who started by asking us to look at their current portfolio and provide an assessment. We pride ourselves on building tailored strategies designed to help our clients’ portfolios before and during retirement.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

1 Georgetown.edu, 2022

2 SSA.gov, November 2022

3 SSA.gov, November 2022