As investors approach retirement, they are faced with a significant threat known as “sequence of returns risk.” This risk, also referred to as “sequence risk,” is often overlooked and misunderstood by retirees, but its impact on their retirement nest egg can be detrimental. The issue arises when poor investment returns coincide with withdrawals, particularly in the early years of retirement, leading to a decline in the overall value of the retirement portfolio.
The Impact on Retirement Nest Egg
Certified financial planner Collin Lyon emphasized the importance of the early retirement years in determining the financial well-being of retirees for the next three decades. The timing of investment returns and withdrawals during this period can have a significant impact on the overall value of the retirement portfolio, making it crucial for retirees to address sequence of returns risk.
Financial advisors suggest several strategies to mitigate sequence of returns risk for retirees. One approach is to adjust portfolio allocations as retirement approaches, by shifting from higher-risk assets to less volatile investments such as bonds. The right mix of assets should be based on factors such as risk tolerance, financial goals, and life expectancy. Diversification among various asset classes can also help reduce the impact of market volatility on the retirement portfolio.
Building Emergency Funds and War Chest
To avoid selling assets during market downturns, retirees can maintain a six-month emergency fund and a “war chest” to cover living expenses. The “war chest” typically consists of five years of expenses in fixed-income assets like bonds or certificate of deposits, providing retirees with a buffer against market volatility. This strategy helps retirees weather the storm during periods of high sequence risk.
Another way to safeguard against sequence of returns risk is to implement flexible withdrawal strategies. Rather than withdrawing a fixed percentage annually, retirees can adjust their withdrawal rates based on market performance. By reducing withdrawals during years of negative returns, retirees can protect the core of their portfolio and ensure its longevity throughout retirement.
Understanding and addressing sequence of returns risk is crucial for retirees as they plan for their financial future. By implementing strategies such as adjusting portfolio allocations, building emergency funds and a “war chest,” and implementing flexible withdrawal strategies, retirees can minimize the negative impact of sequence risk on their retirement nest egg. It is essential for retirees to work closely with financial advisors to develop a comprehensive plan that accounts for sequence of returns risk and ensures long-term financial security.