What Is Sequence of Returns Risk?
August 4, 2023
What Is Sequence of Returns Risk?
August 4, 2023
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Retirement is a long-tail game, in which you need to be able to strategize with some accuracy how much money you will need and the value of your portfolio each year and balance those values with an effective withdrawal strategy so you don’t run out of money in your lifetime.
In the realm of retirement planning, there’s a little-known but highly impactful factor known as sequence of returns (SOR) risk. This risk can have significant implications for those who are nearing or have just entered their retirement years. But what exactly is it?
What Is Sequence of Returns Risk?
So, what exactly is sequence of returns risk? Simply put, it refers to the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual’s underlying investments. More plainly, it’s the risk that the market will perform poorly at the worst possible time for you—namely, when you start withdrawing funds in retirement.
Even with an average return that seems positive, taking out money during a downturn can drastically affect the longevity of your portfolio. Why? Because withdrawing from your investment pot during a down market means you must sell more of your investments to get the cash you need. This, in turn, depletes your savings more rapidly and leaves less capital in your account to benefit from potential future market recoveries and returns.
What Investments Are Most Affected by SOR Risk?
The investments that are most impacted by SOR risk include those that are susceptible to market fluctuations, such as stocks, real estate, and gold. On the other hand, the impact of this type of risk is minimal as it relates to what are considered safe retirement investments, such as U.S. Treasury Bonds, CDs, fixed annuities, savings accounts, and money market accounts.
How to Mitigate SOR Risk
When it comes to mitigating any type of risk, it is imperative to consider best and worst-case market fluctuations. While you may be a glass-half-full kind of person, being ill-prepared against market volatility can be detrimental to your retirement.
There are several ways you can work toward avoiding the consequence of sequence of return risk. Consider these action items to help keep your retirement savings protected:
Diversify Your Portfolio
One of the best tips for investors is to diversify your portfolio. By spreading your investments across various asset classes and securities such as stocks, index funds, target-date funds, bonds, annuities, money market funds, real estate, and commodities, you may help reduce your portfolio’s exposure to market fluctuations. This is because different asset classes tend to behave differently in various market conditions; while some may be performing well, other may be struggling. Ensuring that there is diversity in your investments allows for balance across your portfolio.
Create a Retirement Withdrawal Strategy
When it comes to withdrawal strategies for taking money out of your retirement accounts, Black Rock has several recommendations. Some popular strategies include:
- The 4% Rule: This rule suggests that retirees should withdraw 4% from their investment portfolio within their first year of retirement, and, in subsequent years, continue to withdrawal that 4% annually while also adding on an extra 2% to adjust for inflation. While this has been a go-to strategy for decades, it has been criticized in recent years for being inaccurate due to investors not considering current market volatility and interest rates.
- Fixed-Dollar Withdrawals: This strategy involves retirees withdrawing a fixed dollar amount over a specific period. This is desirable to many retirees because it offers predictable income each year. However, one con of this withdrawal strategy is the fact that it doesn’t account for inflation and could lead to other issues with the market is down.
- Fixed-Percentage Withdrawals: This is like the fixed-dollar withdrawal, except instead of withdrawing a fixed dollar amount over a specific period, retirees withdraw a fixed percentage instead. Many people like this type of strategy due to its simplicity. But a downside is that, even if you take out the same percentage year after year, it will most likely not provide you with the same amount of annual income.
- Systemic Withdrawal Plan: When opting for a systemic withdrawal plan, retirees only take out income that is provided by underlying portfolio investments. This plan is often appealing because it is designed to help prevent retirees from running out of money and allows for the opportunity for investment growth. One thing to consider, though, is that the income you receive with a systemic withdrawal plan will vary due to market fluctuations.
- “Buckets” Strategy: When it comes to retirement withdrawals, many people opt for the “buckets” strategy. Essentially, this strategy involves using three separate types of accounts for your assets. The first “bucket”/account is for some of your cash savings, the second is usually for fixed income securities, and the third is for equities. The idea behind this strategy is that as retirees withdrawal cash from the first “bucket,” they can then use the earnings from the other two “buckets” to build their cash back up. Many people see this as an advantageous process as it provides a way to help grow your savings over time. On the other hand, it is rather tedious to carry out.
Maintain a Reserve
While maintaining a reserve is always recommended, Schwab recommends keeping a “short-term reserve of low-risk liquid investments that you can use to cover your expenses while you avoid tapping your stocks.” Their recommendation involves holding onto:
- A year’s worth of expenses in cash investments
- Three to five years’ worth of expenses in high-quality short-term bonds and cash equivalents
The reason behind doing this? It allows retirees to feel peace of mind knowing they have a healthy reserve set aside that could potentially lead to growth opportunities in the future.
Consider Income Annuities
Investing in income annuities is another thing to consider to combat the sequence of returns risk. For those searching for a guaranteed source of income for the rest of their life, income annuities are a great option as they are not affected by market volatility of interest rates. According to New York Life, “annuity income, which can be higher than income from other fixed-income assets of similar quality due to mortality risk pooling, lowers the withdrawals that retirees need to take to cover expenses.” In turn, this type of annuity will help prevent retirees from having to sell assets when the market is down.
Consult a Financial Professional
By working with a financial professional one can benefit from their expertise in creating a well-diversified investment portfolio that considers the individual’s risk tolerance and financial goals. These professionals can develop a comprehensive financial plan that considers the potential impact of market volatility on retirement savings. They can guide retirees in adjusting financial strategies, and help individuals manage their cash flow during retirement to prevent the need to sell investments during market downturns. By providing personalized advice, financial professionals can play a crucial role in mitigating SOR risk and enhancing long-term financial security.
Sequence of returns risk is a vital consideration for any investor, especially those approaching retirement. Understanding the implications and taking appropriate steps to avoid this risk can help protect your financial well-being. Remember, investing always carries some degree of risk, but our team is here to help. Contact us today to learn more about our services.
This blog expresses the author’s views as of the date indicated, are subject to change without notice, and may not be updated. The information contained within is believed to be from reliable sources. However, its accurateness, completeness, and the opinions based thereon by the author are not guaranteed – no responsibility is assumed for omissions or errors. This blog aims to expose you to ideas and financial vehicles that may help you work towards your financial goals. No promises or guarantees are made that you will accomplish such goals.
Past performance is no guarantee of future results, and any expected returns or hypothetical projections may not reflect actual future performance or outcomes. All investments involve risk and may lose money. Nothing in this document should be construed as investment, tax, financial, accounting, or legal advice. Each prospective investor must evaluate and investigate any investments considered or any investment strategies or recommendations described herein (including the risks and merits thereof), seek professional advice for their particular circumstances, and inform themselves about the tax or other consequences of any investments or services considered.
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Black Rock. (n.d.). What are Retirement Withdrawal Strategies? https://www.blackrock.com/us/individual/education/retirement/withdrawal-rules-and-strategies
Charles Schwab. (April 6, 2022). Timing Matters: Understanding Sequence of Returns Risk. https://www.schwab.com/learn/story/timing-matters-understanding-sequence-returns-risk
Huang, Dylan. (n.d.). How to Protect Against Sequence-of-Returns Risk. New York Life. https://www.newyorklife.com/articles/sequence-returns-risk
Kagan, Julia. (November 20, 2020). Sequence Risk: Meaning, Retirement, Protection. Investopedia. https://www.investopedia.com/terms/s/sequence-risk.asp
Plummer, Shawn. (n.d.). Sequence Of Returns Risk For Retirement: Understanding Its Implications For Investors. The Annuity Expert. https://www.annuityexpertadvice.com/sequence-of-returns-risk/
Woodruff, Dierdre. (n.d.). Where Is the Safest Place to Put Your Retirement Money? Canvas. https://canvasannuity.com/blog/safest-place-for-retirement-savings