By: Joseph Goldy, CFP®
What is Sequence Risk?
Investors face many risks. Sequence-of-returns risk has not been discussed much over the last decade. Sequence risk is the risk of an investor experiencing a down market while simultaneously needing to begin withdrawals from your portfolio.
Understandably, sequence risk has not been top-of-mind for many retirees due to the 12-year bull market that began in 2009 and just recently ended. However, the current bear market and high inflation have underscored the importance of understanding sequence risk and finding ways to help mitigate it.
Timing is Everything
To understand the influence sequence risk can have on a portfolio, researchers at Vanguard Group conducted a study comparing how retirees' portfolios fared in each of the six bear markets in the U.S. since 1926. Their goal was to see how retiring at the start of a market downturn might affect the chances of a retiree running out of money.
The researchers looked at two hypothetical retirees, each with a $500,000 portfolio and taking annual withdrawals of $25,000 or 5% of the portfolio value. One person retired in 1973 during a bear market, and the other retired just one year later in 1974, when the market was recovering.
As seen in the graph below, the results showed the impact sequence risk could have on a retiree's portfolio.
The sequence of returns for the person retiring in 1973 depleted the portfolio after about 23 years. In contrast, the person retiring in 1974 not only maintained a balance throughout the retirement period but still had over $100,000 left at the end of their plan.
One of the most dangerous aspects of sequence risk is that investors don't feel the impact at first and thus may not take the necessary steps to help lessen the effects of this risk.
Yet, as highlighted in the Vanguard study, experiencing a bad market at the beginning of retirement can dramatically impact the odds of running out of money over the long run. The reason for this has to do with opportunity cost.
When a retiree begins withdrawals from their portfolio, every dollar coming out is effectively locking in a loss while the market is down. Additionally, those dollars are being removed from the portfolio and missing out on future growth. In a sense, it's like compounding but in reverse.
Ways to Mitigate Sequence Risk
Have a Plan
At HIGHLAND, we talk to clients about their retirement in terms of a transition from relying on their human capital (earning a paycheck from working) to counting on their investment capital to provide a regular monthly "paycheck."
We discuss with clients the three things that any successful portfolio income strategy must achieve:
Keep pace with inflation
Provide consistency
Be independent of stock market returns
The risk of "bad timing" is always part of our conversation and is factored into a client's plan. We model the impact of a significant market decline in the first years of retirement so people can see the effect of sequence risk and take any necessary steps to ensure their plan stays on track.
When a client experiences high unforeseen expenses early in retirement, it is necessary to have honest and open conversations. We discuss the impact unchecked portfolio withdrawals in a down market (plus higher-than-average inflation) can have on their plan's success and work one-on-one with them to build flexibility into their planning and carefully review their cash flow.
Working Longer
One of the most obvious ways to eliminate sequence risk is to delay retiring. Working a little longer is one of the easiest ways to mitigate sequence risk if someone is open to it. Unfortunately, this may not be an option for some due to health reasons or the inability to reenter the workforce.
It's important to note that working just six months or a year longer is often enough to help mitigate sequence risk. The goal is simply prolonging any portfolio withdrawals until the worst of the bear market has passed.
Cutting Fixed Expenses
Cutting back is another way to help protect against sequence risk. Reducing expenses, even just a small amount annually, is remarkably impactful on portfolio outcomes since every expense paid until your plan's end inflates by about 2%-3%. For example, a $10,000 annual expenditure today will have grown to $18,539 over 25 years if inflation averages 2.5%.
Retirement is a time to enjoy all the things you may have put off during your working years. And while it's never pleasant retiring in a down market, having a plan, being flexible in your retirement date, and keeping spending in check, are all ways to ensure sequence risk doesn't derail this well-deserved part of your life.
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.