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Sequence of returns risk: What it means for your retirement

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Alistair Berg/Getty Images

As you set out on your retirement journey, you want to make the most of your money and stay on the road to financial stability. That's why, if you have investments as part of your retirement strategy, it's important to be aware of an unpredictable factor known as sequence of returns risk, or sequencing risk. Understanding it can help you stay on track to maximize your retirement withdrawals.

What is sequence of returns risk?

Sequence of returns risk is the danger of poor investment performance early in the withdrawal phase of your retirement years. With little time to make up for losses and the combination of withdrawals, it can be threatening to retirees or those soon to retire.

Sequence of returns risk example

Let's say an investor begins their retirement with a $1 million investment portfolio. In the first few years of their retirement, some unfortunate market downturns occur resulting in negative investment returns. The investor, who needs to make regular withdrawals from the account to cover their retirement living expenses, is forced to sell assets during this downturn.

In this situation, not only did the portfolio suffer immediate losses due to market conditions, but the retiree's need to withdraw from the account locked in those losses, notching down the overall value of the portfolio. The risk is that the portfolio won't be able to recover. Even if the market rebounds in subsequent years, the early blow will leave a lasting impact.

This is the primary point to know about sequence of returns risk: The timing of necessary withdrawals with market fluctuations can significantly influence the longevity and sustainability of your nest egg. It's one of the main reasons that strategic financial planning throughout your life is so important.

How sequence of returns risk can affect portfolio value

Sequence of returns risk is greatest during the early withdrawal phase of retirement investments. Here's a breakdown of the key characteristics of this potential danger, its ongoing impact on portfolio value, and potential long-term consequences:

  • Early market downturns. If you experience a significant market downturn early in your retirement when you're making withdrawals from your investment portfolio, it can have a long-lasting effect on the portfolio's ability to recover.
  • Impact on portfolio value. Poor returns in the initial years of your retirement can deplete your portfolio faster than anticipated, reducing the overall value available for future years.
  • Increased withdrawal impact. When you make withdrawals for your living expenses during a market downturn, a higher percentage of the portfolio ends up being taken out, which can further diminish your remaining investment assets.
  • Long-term consequences. Even if the market recovers in subsequent years, the portfolio may not fully recover due to the reduced principal resulting from earlier withdrawals.
  • Potential exhaustion of assets. Sequence of returns risk increases the possibility you'll outlive your savings, especially if your early retirement years coincide with a prolonged bear market.
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8 ways to manage sequence of returns risk

Mitigating sequence of returns risk in retirement involves adopting strategies to navigate market uncertainties and safeguard the sustainability of your financial plan. Here are some approaches that can be effective:

1. The 4% rule

The 4% rule suggests beginning your annual retirement withdrawals at a rate of 4% of the initial portfolio value and then adjusting for inflation in subsequent years. This strategy aims to provide you with a steady income stream while minimizing the effect of market volatility on long-term sustainability.

While the rule can be used effectively, it can also be too conservative and may not provide a large enough portion of your portfolio for you to have enough annual income.

2. The bucket approach

This strategy involves dividing the investment portfolio into different "buckets" based on your time horizon and risk tolerance. Short-term buckets hold cash or conservative investments to cover immediate expenses, while long-term buckets remain invested for growth, allowing for potential recovery from market downturns.

The idea is that income you need now or in the next few years is not invested in growth investments like stocks, which can be more volatile in the short term.

3. Timing of Social Security benefits

Delaying the start of Social Security benefits can help you hedge against sequence of returns risk. By postponing benefits for a few years, you can increase your Social Security income, providing a more stable income stream during the early, vulnerable years of retirement.

4. Diversification

A well-diversified portfolio spreads your investments across different asset classes, which may reduce the impact of poor performance in any single sector.1 Diverse asset allocation helps manage risk and enhances your portfolio's resilience against market fluctuations.

For example, retirement assets that you don't need for at least 10 years can remain invested in riskier assets like growth stocks while assets you need sooner can be invested in a mix of dividend stocks, funds and bonds.

5. Tax considerations

Tax-efficient withdrawal strategies can help minimize the tax impact on retirement income. Strategically using a combination of taxable, tax-deferred and tax-free accounts can optimize after-tax income and preserve your overall portfolio.

For example, it's generally more tax-efficient to withdraw from taxable accounts earlier in retirement while allowing nontaxable account assets, such as those in IRAs, to continue growing tax-deferred as long as possible.

6. Flexible withdrawal strategies

Adopting a flexible approach to withdrawals allows you to adjust your spending based on market conditions. During favorable market periods, you may withdraw more, while in challenging times, you can tighten your belt to preserve the portfolio.

7. Regular portfolio rebalancing

Periodic assessment and adjustment can help ensure that your portfolio maintains its target asset allocation. This practice prevents overexposure to riskier assets and aligns your portfolio with your risk tolerance and financial goals.

8. Longevity planning

Considering longevity risk is essential. As a retiree, you should plan for a longer retirement horizon and ensure that your financial strategy accounts for potential medical expenses, long-term care and other factors that may arise in later years.

Getting help with sequence of returns risk

Understanding and addressing sequence of returns risk helps ensure your financial well-being throughout retirement. Having a well-structured investment strategy that considers the timing of market returns, especially during the important initial years of retirement, can help mitigate sequence of returns risk and maximize your retirement withdrawals.

To find a strategy that works for you, consider consulting with a Thrivent financial advisor.

1 While diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market.

Hypothetical example is for illustrative purposes. May not be representative of actual results. Past performance is not necessarily indicative of future results.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.

Thrivent financial advisors and professionals have general knowledge of the Social Security tenets. For complete details on your situation, contact the Social Security Administration.
Investing involves risks, including the possible loss of principal.