Why Sequence of Return Risk Could Derail Your Retirement Dreams
Imagine you’ve spent decades saving for retirement, and you finally reach that coveted $2 million mark. You’re ready to kick back, travel, and enjoy life. But what if I told you there’s a hidden danger lurking in your retirement plan that could wipe out your savings in just a decade? This danger is called sequence of return risk, and it’s the number one reason why two people with identical portfolios can end up with drastically different retirement outcomes.
Let’s dive into this critical issue and explore how you can protect your hard-earned savings.
What is Sequence of Return Risk?
Sequence of return risk refers to the potential negative impact of the order in which your investment returns occur, especially during the early years of retirement.
The Problem: If you experience poor market returns early in retirement, it can significantly affect your portfolio's longevity, even if the long-term returns are favorable.
The Reality: Two retirees, Tom and Giselle, both with $2 million and planning to withdraw $80,000 annually, can have vastly different experiences based solely on when they retire.
A Tale of Two Retirees
Let’s break down Tom and Giselle’s scenarios:
Tom: Retires before a bull market. In his first two years, he sees modest gains of 4% and 6%. His portfolio remains intact.
Giselle: Retires just before a market crash. She faces a 20% drop in her first year, followed by a flat market. She’s forced to withdraw the same $80,000, but now from a diminished portfolio.
The Math Behind the Madness
Giselle’s Situation:
Starts with $2 million.
Year 1: Portfolio drops to $1.6 million after a 20% loss.
Withdraws $80,000, leaving her with $1.52 million.
Year 2: Portfolio remains flat. Withdraws another $80,000, reducing her balance to $1.44 million.
Tom’s Situation:
Starts with $2 million.
Year 1: Gains 4%, bringing his total to $2.08 million.
Year 2: Gains 6%, increasing his total to $2.20 million.
The difference? Timing. Tom’s portfolio grows, while Giselle’s shrinks, illustrating how sequence of return risk can devastate retirement plans.
Strategies to Mitigate Sequence of Return Risk
Understanding this risk is the first step. The next is to implement strategies that can help you navigate these turbulent waters. Here are three effective strategies:
1. The Cash Runway
What It Is: Keep two to three years of living expenses in high-yield cash.
Why It Works: Most market downturns recover within two years. By using cash for your expenses, you allow your investments to recover without being forced to sell at a loss.
2. The Bond Buffer
What It Is: Allocate years three through five of living expenses into ultra-safe bonds.
Why It Works: Bonds can provide stability during market volatility. They may not offer the same growth potential as stocks, but they can help preserve your capital when the market takes a hit.
3. Dynamic Withdrawal Guardrails
What It Is: Adjust your spending based on your portfolio’s performance.
How It Works: If your portfolio drops 20%, reduce your spending by 10%. Conversely, if it rises 20%, you can increase your spending by 10%. This strategy allows for flexibility and can extend your portfolio's life.
The Importance of Timing
It’s not just about having these strategies; it’s about knowing when to implement them. The first decade of retirement is the most critical.
Years 1-10: Focus on being defensive and protecting your assets.
Years 11 and Beyond: If you’ve successfully navigated the sequence of return risk, you can afford to be more aggressive with your investments.
Think of it like an NBA game. The first quarter sets the tone, but if you play your cards right, you can adjust your strategy in the second half to come out on top.
Final Thoughts
Sequence of return risk is a hidden danger that can derail even the best-laid retirement plans. By understanding this risk and implementing strategies like the cash runway, bond buffer, and dynamic withdrawal guardrails, you can protect your hard-earned savings and enjoy your retirement to the fullest.
For a deeper dive into these strategies and more, be sure to check out the full video on our website.
Education only, not advice. Consult your professional(s).