Markets go up and down in ways that are not entirely predictable. For long-term investors, what the market is doing in the present isn’t that troubling; they’ve got a long time to ride out potential downturns. But for recent retirees, an ill-timed market downturn can have a negative impact on their nest egg, increasing the chances they’ll outlive their money. It’s a risk all investors face, and, fortunately, there are several things you can do to mitigate it.
What is Sequence of Returns Risk?
Sequence of returns risk is the risk that your portfolio will experience large negative returns just as you shift from making contributions to making withdrawals.
In 1994, William P. Bengen ran simulations based on historical investment performance data to show that, during retirement, when individuals draw down investments – and not just the average returns over time – they could hugely impact their finances. The same hypothetical portfolio at a 5% withdrawal rate could last as long as 50 years or as short as 20 years – all depending on when the retiree began taking distributions.1 The reason: Negative returns early in retirement could deplete portfolios while offering little opportunity to recover as retirees continued to make withdrawals. This can have a serious impact on a portfolio’s longevity.
Bengen’s research popularized the Four Percent Rule — a rule of thumb that recommends withdrawing no more than 4% of your investment assets every year to lower the risk that an inopportune market downturn will deplete your nest egg and cause you to outlive your money.
What Can You Do to Mitigate Sequence of Returns Risk?
There are several things you can do to soften the impact that sequence of returns can have on your financial goals in retirement.
Be prepared to scale back spending. An obvious, but perhaps challenging, risk mitigation strategy is to plan to withdraw less from investments. That could mean adhering to a low withdrawal rate from the beginning to lower the chance of a shortfall. Or it could mean preparing to scale back later in retirement if it becomes necessary. It depends on your priorities and individual risk tolerance. For example, a 2012 study by Michael Finke and others suggested that some retirees may prefer a withdrawal rate as high as 7% even if it increases the likelihood they will have to scale back later in retirement.2
1 William P. Bengen. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning. October 1994. https://www.retailinvestor.org/pdf/Bengen1.pdf
2 Michael Finke, Wade D. Pfau and Duncan Williams. “Spending Flexibility and Safe Withdrawal Rates.” Financial Planning Association. March 2012. https://www.financialplanningassociation.org/article/journal/MAR12-spending-flexibility-and-safe-withdrawal-rates
Maintain a reserve of cash and short-term bonds. If you have the choice, consider covering expenses with cash reserves, or withdraw from bonds, during down years. By doing so, you avoid selling stocks after prices have fallen and you’ll have more money in stocks to take advantage of a potential recovery.
Tap into home equity. If you’re a homeowner, the equity in your home can be a valuable source of funds when markets are down. To turn that equity into cash, consider downsizing into a less expensive home. If you’re staying put, you can borrow against the equity in your home with a reverse mortgage. The loan is repaid when you no longer live in your home and it is sold. However, if you take advantage of a reverse mortgage, you won’t be able to leave your home to your heirs.
Purchase an income annuity. An annuity is a contract under which you make one or several payments to an insurance company. In return, the company agrees to make regular payments to you over a defined period of time in the future. If you’re worried about a market downturn depleting your nest egg, they can potentially be a source of guaranteed income. That said, annuities aren’t right for everyone. Talk to a financial professional to decide where an annuity or other risk management strategies fit into your overall financial plan.