One of the most significant risks retirees face is market volatility, especially in the early years of retirement. This is known as sequence of return risk, where a market drop at the wrong time can severely impact your retirement, potentially making it difficult to recover.
Understanding Sequence of Return Risk
Sequence of return risk refers to the danger that a market downturn in the early years of retirement can have a lasting negative impact on your portfolio. If the stock market takes a significant hit just as you start drawing down your retirement savings, the impact can be severe and may cause you to run out of money sooner than planned.
This risk is highest during the first five years of retirement.
The chart above illustrates a hypothetical 60 year investing lifecycle. The first 30 years are working years, while the second 30-year period is retirement. The large spike shown in the graph is the first year of retirement.
Strategies to Mitigate Market Risk
Spend Conservatively: One way to protect your retirement is to start with a conservative spending approach. The well-known 4% rule suggests an appropriate initial spending amount of 4% of your starting portfolio, then adjusted for inflation each year. This strategy has historically worked to sustain a 30-year retirement using a balanced 60/40 portfolio. Notice in the chart below this is based on the lowest safe withdrawal rate for a portfolio.
Additionally starting at a conservative spending amount (4% rule) and adjusting your spending upward when markets perform well, could also work.
Embrace Spending Flexibility: If you're willing to reduce your spending during market downturns, you can significantly improve your portfolio's longevity, and spend more earlier in retirement. For example, cutting back on expenses when your portfolio takes a hit can help preserve your savings for the long term.
Reduce Market Risk with the Bond Tent Strategy: As you approach retirement, consider reducing your stock market exposure. The "bond tent" strategy involves increasing the proportion of bonds in your portfolio as you near retirement and then gradually reintroducing equities as your sequence of return risk diminishes.
Build a Cash Buffer: Consider establishing a cash reserve to cover your living expenses for 3-5 years. This one-time safety net can be can be tapped into when your portfolio is down, allowing you to avoid selling assets at a loss during challenging market periods.
Utilize Other Buffer Assets: In addition to a cash buffer, consider other assets like home equity or part-time work as a fallback option during market downturns. These can provide additional financial flexibility and reduce the need to draw from your portfolio when markets are down.
Re-evaluate Social Security Timing: In times of market stress, it may be beneficial for one spouse to start benefits early to reduce the draw on your investment portfolio.
Conclusion
The first few years of retirement are critical for your financial future. By understanding the sequence of return risk and implementing strategies to mitigate that risk you can better protect your retirement.
I’m here to assist you in managing these risks and ensuring your retirement plan is equipped to handle any market shifts. Reach out today to explore how we can adapt these strategies to fit your situation.
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