Understanding sequence risk and its effect on retirement planning

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There is a lot to think about when planning for retirement. While we have a degree of control over many of the choices involved, there is one big wild card we cannot control called sequence risk.

Sequence risk is the risk that you will encounter negative investment returns in early retirement when you are regularly withdrawing but not contributing funds to your accounts. This is an important consideration because the random sequence — or order — in which you earn your returns early in retirement can have a significant impact on your lasting wealth.

Simply put, a retirement portfolio that happens to experience positive returns early in retirement will outlast an identical portfolio that must endure negative returns early in retirement, even if their long-term rates of return end up the same.

Since nobody can predict which return sequence they will experience early in their retirement, every family should prepare for a realistic range of possibilities in their retirement planning.

The significance of sequence risk

As 2020 has shown, global stock markets are volatile. While the historic long-term average annual returns may be in the range of 6-7%, markets rarely deliver this exact average in any given year. Soaring one year, plummeting the next; we never know for sure how far above or below average each year will be.

During your career, you are mostly spending earned income, while adding to your retirement reserves as aggressively as your plans call for. As long as you stay the course — benefiting from the upswings and enduring the downturns — tolerating market volatility is just part of the plan.

In fact, when you are still accumulating wealth, market downturns allow you to buy more shares than you otherwise could when prices are higher. When the market recovers, you then have more shares to recover with, which ultimately strengthens your portfolio.

But then, you stop working and start spending your reserves. This has the opposite effect. If your early retirement years occur during a stock market decline, or a bear market, your withdrawals use more of your balance and are not offset by new contributions.

In a bear market, you may need to sell shares at low prices, which means you will have to sell more of them to withdraw the same amount of cash. Even though the market is expected to eventually recover and continue upward, your portfolio will have fewer shares with which to participate in the recovery. This hurts your portfolio’s staying power. It will not be able to bounce back as readily as when you were adding shares to it or at least not taking them away. Some retirees will never experience a full account recovery.

Managing the sequence risk wild card

Sequence risk should not change your overall approach to investing. As 2020 has clearly shown us, you never know what is going to happen next. Crashes usually occur without warning, while some of the strongest rebounds arrive amidst the darkest days.

If sequence risk is impossible to control or predict, what can you do to mitigate it if it happens to you?

Keep working: If you are willing and able, you might postpone retirement or even return to the workforce. Even part-time employment can help offset an unexpected and ill-timed sequence of negative market returns. If your circumstances allow, you may be able to not only avoid spending retirement reserves during down markets but even add more in by buying at bargain prices.

Spend less: Were you planning for higher investment returns than reality has delivered? Since your portfolio is most vulnerable to negative sequence risks early in retirement, you may want to initially spend less than planned to give your portfolio the fuel it needs to replenish itself.

Tap other assets: When you retire, you typically have several sources of income to draw from. You may have traditional investment accounts, retirement accounts, Social Security or pension plans. Your investments are usually divided between stocks and bonds. You may have equity in your home. You may have cash reserves. If you encounter stock market sequence risk early in retirement, you might be able to tap a combination of your nonstock assets for initial spending needs. This can mitigate the hit your portfolio will otherwise have to take if you must liquidate shares of stock.

Consult with a financial adviser: Sequence risk is usually not the only consideration at play in retirement planning. There are taxes to consider, estate plans and charitable goals to bear in mind, carefully structured investment portfolios to maintain and logistics to learn. All this speaks to the value an experienced adviser can add before, during and after this pivotal time in your financial journey.

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