Sequence Risk: Investing's Unseen Danger

Sequence risk, or sequence-of-returns risk, is the danger that the timing of withdrawals from a retirement account will negatively impact the overall rate of return available to the investor. This is especially important for retirees who depend on their portfolio to live off of. Sequence risk can be understood as a roller-coaster ride for your savings. If investment returns are poor early in retirement or when withdrawing funds, it can deplete savings more quickly. Even if investments recover later, the initial losses can harm long-term financial health. This is because there are fewer assets left to benefit from potential market recoveries in subsequent periods.

Sequence risk is the danger that the timing of withdrawals from a retirement account will negatively impact the overall rate of return

Sequence risk is a critical concept in retirement planning that deals with the potential impact of market downturns on retirement savings. It refers to the danger that the timing of withdrawals from a retirement account will negatively affect the overall rate of return. This risk is often referred to as "sequence of returns risk" or "sequence of investment returns risk."

When you withdraw funds from your retirement account, the order or sequence of returns can significantly impact the longevity of your retirement portfolio. For example, if your investments experience negative returns or poor performance just before or during the initial years of retirement, when you start making withdrawals, it can have a detrimental effect on your retirement savings. This is because you are not only withdrawing funds but also potentially selling investments to generate cash, locking in those losses.

The impact of sequence risk can be significant. Let's consider an example: assume you have a retirement portfolio worth $1,000,000, and you plan to withdraw $40,000 annually for your living expenses. In one scenario, your portfolio experiences a 50% loss in the first year, just as you begin your withdrawals. This means your $40,000 withdrawal becomes a sale of investments, locking in that loss. Even if the portfolio recovers and earns a positive return in subsequent years, it will be challenging to recoup those initial losses due to the reduced base. On the other hand, if the same sequence of returns occurs earlier in your career, when you're contributing to your retirement account, the impact is less severe since purchases of investments at lower prices can help offset the losses.

Managing sequence risk is crucial for a secure retirement. Here are some strategies to consider: 1. Maintain a diversified portfolio: Diversification helps spread risk across different asset classes and investment types. By allocating your retirement savings across a mix of stocks, bonds, and other investments, you can reduce the impact of market volatility and improve the potential for long-term growth. 2. Adjust your asset allocation over time: As you approach retirement and enter retirement, consider adjusting your asset allocation to become more conservative. Typically, this involves reducing the proportion of stocks in your portfolio and increasing the allocation to bonds and other less volatile investments. This can help minimize the impact of market downturns on your retirement funds.

Create a retirement income plan: Develop a comprehensive plan that considers your retirement income needs, expected expenses, and sources of income, such as Social Security, pensions, and retirement account withdrawals. This plan can guide you in determining a sustainable withdrawal rate that considers sequence risk. 4. Consider guaranteed income sources: Explore options for guaranteed income streams during retirement, such as annuities or certain types of pension payments. These can provide a stable base of income that is not directly impacted by market fluctuations. 5. Be flexible with your retirement budget: Maintain some flexibility in your retirement budget, especially in the initial years. If your portfolio experiences losses, you may need to adjust your spending temporarily to give your investments time to recover.

In conclusion, sequence risk is an important consideration for anyone planning for retirement. By understanding how the timing of market returns can impact your retirement savings, you can take appropriate steps to mitigate this risk and improve the likelihood of a comfortable and secure retirement. Working with a financial advisor who can provide personalized advice and strategies is always recommended to address sequence risk effectively.

Sequence risk is also called sequence-of-returns risk

Sequence risk, also known as sequence-of-returns risk, refers to the danger that the timing of withdrawals from a retirement account will negatively impact the overall rate of return available to the investor. This is especially important for retirees who depend on their portfolio for income and are no longer contributing new capital to offset losses.

Sequence-of-returns risk can be understood as a rollercoaster ride for your savings. The order and timing of poor investment returns can have a significant impact on the longevity of a retiree's savings. If a retiree experiences a market drop in the early years of retirement, they will have to sell more investments to cover their expenses, depleting their savings more quickly. This leaves fewer assets to benefit from potential market recoveries in subsequent periods. Conversely, positive returns in the early stages of retirement can positively influence the longevity of a portfolio, especially if the early portfolio balance is high.

For example, consider two retirees, both starting with a $500,000 portfolio, with the plan of withdrawing $25,000 per year, assuming the same average net rate of return. One retiree experiences positive returns when they retire, resulting in a projection of more money when they are 95. The second retiree experiences negative returns and runs out of money in their mid-70s. This example demonstrates how sequence-of-returns risk can have a catastrophic impact on retirement savings.

To mitigate sequence-of-returns risk, retirees can adopt a gradual allocation path, starting with more aggressive investments when they are young and slowly becoming less aggressive as they get older. Additionally, retirees can consider keeping a year's worth of expenses in cash and another two to four years' worth in high-quality short-term bonds or bond funds. This allows retirees to avoid selling investments when the market is down and gives their portfolio a chance to recover.

Sequence risk can be mitigated by keeping a year's worth of expenses in cash investments

Sequence risk, or "sequence-of-returns risk", refers to the danger that the timing of withdrawals from a retirement account will negatively impact the overall rate of return available to the investor. This is especially important for retirees who depend on their portfolio for income and are no longer contributing new capital to offset losses.

The bucket strategy typically involves allocating a portfolio into three areas:

• The short-term bucket for immediate expenses, which can include a year's worth of expenses in cash investments.
• The intermediate-term bucket for upcoming needs, which can include two to five years' worth of expenses in high-quality short-term bonds or bond funds.
• The long-term bucket for future growth, which can include stocks and other types of bonds or bond funds.

By implementing this strategy, retirees can have a secure source of income for their current needs while allowing the rest of their portfolio to grow over time. It is important to note that this strategy may not be suitable for everyone, and it is always recommended to consult with a financial advisor before making any investment decisions.

Sequence risk can be mitigated by keeping two to four years' worth of expenses in high-quality short-term bonds

Sequence risk, or "sequence-of-returns risk", refers to the danger that the timing of withdrawals from a retirement account will negatively impact the overall rate of return available to the investor. In other words, if a portfolio experiences negative returns when withdrawals are being made, especially during retirement, it can have a lasting adverse effect on the portfolio's value. This is because there are fewer assets left to benefit from potential market recoveries in subsequent periods.

One way to mitigate sequence risk is to keep two years' worth of income in cash and two to four years' worth of expenses in high-quality short-term bonds or short-term bond funds. This strategy can be included as part of a retiree's overall retirement portfolio, which can also include a personalised mix of cash, cash investments, and stocks. By having a reserve of low-risk liquid investments, retirees can avoid having to sell their stocks when the market is down and give their portfolio a chance to recover. This approach can also make retirees feel more comfortable about having a significant portion of stocks in their portfolio, which can generate growth later on.

Sequence risk can be mitigated by having a diverse portfolio

Sequence risk, or "sequence-of-returns risk", is the danger that the timing of withdrawals from a retirement account will negatively impact the overall rate of return available to the investor. This is particularly important for retirees who depend on this income and are no longer contributing new capital to offset losses.

• Keep a cash reserve: It is recommended to keep a year's worth of expenses in cash investments and another two to four years' worth in high-quality short-term bonds or bond funds. This allows you to avoid selling stocks when the market is down and gives your portfolio time to recover.
• Diversify your portfolio: Invest in a mix of cash, cash investments, short-term bonds, and stocks. This helps to balance risk and return, ensuring you have a secure source of income while allowing the rest of your portfolio to grow.
• Adjust your asset allocation: Shift some of your higher-risk investments to low or medium-risk options, especially as you approach retirement. This could include U.S. Treasury bonds, Treasury Inflation-Protected Securities (TIPS), U.S. Savings Bonds, annuities, and high-dividend stocks.
• Plan for market downturns: Anticipate a worst-case scenario and be prepared to adjust your withdrawal rate if needed.
• Keep an emergency fund: Having a separate emergency fund can help you avoid touching your investment portfolio during market downturns.

By implementing these strategies, you can reduce the impact of sequence risk and protect your retirement savings.

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