Managing Sequence-of-Returns Risk in the Early Years of Retirement
Why the order of investment returns matters far more once withdrawals begin, and practical strategies to reduce the danger of early losses.
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Sequence-of-returns risk is the danger that poor investment returns in the early years of retirement—when withdrawals are being made—can permanently impair a portfolio’s ability to sustain spending, even if average returns over the full retirement period are satisfactory.
Why Sequence Matters
When a portfolio declines and withdrawals continue, more shares must be sold to generate the same dollar amount of income. Those shares are then unavailable to participate in any subsequent recovery. The mathematical effect can be severe: two retirees with identical average returns and identical withdrawal amounts can experience dramatically different outcomes solely because of the order in which the returns occurred.
Practical Mitigation Strategies
Mitigation strategies used by asset management professionals include:
Maintaining a cash or short-term bond reserve covering several years of planned withdrawals, so that equities need not be sold during a downturn.
Adopting a flexible withdrawal policy that reduces spending temporarily after significant market declines.
Using a rising equity glide path in some cases (starting retirement with a moderate equity allocation and gradually increasing it), which research has shown can improve outcomes under certain conditions.
Diversifying sources of income so that the portfolio is not the sole support during stressed periods.
Considering partial annuitization of essential expenses to create a floor of guaranteed income.
Stress-testing the retirement plan against historical and hypothetical poor-sequence scenarios is an essential part of prudent planning. Clients who understand the risk and have deliberate buffers in place are better positioned to stay the course when markets are difficult.
Addressing sequence risk is one of the most valuable services an asset management firm provides to clients approaching or entering retirement.
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