When it comes to retirement planning, investors need to defend against a hidden risk that follows a sharp market downturn. The timing, or sequence, of falling markets early in retirement can drain retirement assets and affect people's lifestyle for years to come.
It's called the sequence of return risk. In this situation, investors encounter a substantial drop in the market as they enter retirement or in the early years of their retirement. The word "sequence" is key here.
Timing matters. A steep decline at the beginning of an investor's retirement can dramatically impact the ability of their retirement nest egg to support their needs during a normal retirement period.
Picture this: You've just stopped working. You've just begun taking money from your retirement accounts. Your withdrawals usually are based on a certain level of assets.
Now, a significant market downturn, say 20% or even 10%, at the onset of retirement can really put a dent in your retirement assets.
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Retirement Planning: You Don't Want To 'Unretire'
Back in the financial crisis of 2007-2008, there were many stories of people who suffered from some form of sequence of return risk. For 2008, the S&P 500 declined more than 38%, hitting the portfolios of many recently retired investors. In some cases, those investors felt the need to return to work in some capacity to supplement their now significantly depleted retirement savings.
Rob Williams, managing director of financial planning, retirement income and wealth management at the Schwab Center for Financial Research, says, "If the decline is steep or lasts a while, that could make it even harder to recover. So, the question becomes: How can you help minimize the lost ground?"
There are a number of tactics and strategies that investors can use to minimize sequence of return risk.
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Retirement Planning With The Bucket Strategy
Devin Carroll, a CFP and co-host of the Big Picture Retirement podcast, suggests, "The best way I've found to mitigate the sequence of returns risk is to have a 'spending bucket' that covers as much as five years of distribution needs. Ideally, this spending bucket will have laddered CDs, Treasuries or some other fixed income security that will return a specific amount on a specific date."
He adds, "Since the average peak-back-to-peak bear market is 2.8 years, five years is usually plenty of time for a full recovery to prevent selling investments in a down market. For those who want even more of a hedge, they can consider a six- or seven-year bucket."
Typically this approach will employ three buckets. As Carroll pointed out, the low-risk or spending bucket is used to fund current spending.
An intermediate bucket covers needs beyond the term covered by the spending bucket. This bucket is generally funded with moderate risk investments like dividend-paying stocks, intermediate-term bonds and CDs.
The longer-term bucket is geared toward growth and generally contains stocks and other growth-oriented investments. Assets from the intermediate bucket eventually move to the spending bucket. Then assets from the longer-term bucket move to the intermediate bucket as needed.
Portfolio Diversification Is Crucial
Even with a plan like the bucket strategy, portfolio diversification is still crucial to ensure proper growth and to mitigate portfolio risk across your holdings. This applies to the longer-term bucket, but also to the short- and intermediate-term buckets as well.
Sharp investors use diversification throughout the years of building their retirement savings. During retirement, or the decumulation phase, it's equally important. Diversification offers the combination of growth and risk mitigation needed to help ensure your retirement assets last through your retirement.
Tax Planning For Distributions
Poor tax planning in terms of distributions from retirement accounts such as a traditional IRA or 401(k) can deplete assets as well. When coupled with the impact of a sequence of returns risk, the combination can devastate your retirement savings.
While taxes should not govern your retirement planning, they can be significant and should be minimized. Decide which accounts to tap in a given year based on your overall tax situation for that year. Proper tax planning can mitigate the impact of taxes. It also can reduce the damage caused by a sequence of returns occurrence.
Retirement Planning Involves Good Budgeting
Even in retirement, budgeting and spending control are important. Figure how much spending your nest egg can reasonably support and factor in any income from other sources that you will have in retirement.
After that, spend accordingly. Enjoy life in retirement. However, if you deplete too much of your nest egg too early, it can be difficult to recover.
Manage Social Security And Pensions
As part of your retirement income strategy, be sure to factor in any Social Security and pension benefits. Determine the best time to claim these benefits based on any tax implications. And maximize the benefit to the extent possible. Social Security and pension benefits can help preserve assets in various retirement accounts under normal market conditions. If you are hit with a severe market downturn early in retirement, they can be a key source of income that can allow your portfolio time to recover.
Sequence of returns risk is a very real risk for those entering or early in retirement. For those who are unprepared, a sequence of returns event can force drastic changes in retirement plans. You don't want to be forced to "unretire." Be sure to take steps to mitigate this risk before entering your retirement years.
