Navigating Sequence-of-Returns Risk: Strategies to Protect Your Retirement Savings
Retirement planning is one of the most critical phases of our financial lives, as it sets the tone for the remainder of our days. However, while most of us envision retirement as an idyllic time to relax and enjoy our golden years, it can be a period of financial insecurity if not approached correctly. Inflation, rising healthcare costs, market turbulence, and a litany of other factors can deplete our retirement portfolios more quickly than expected – and one potential danger that’s often overlooked is sequence-of-returns risk.
Put simply, sequence-of-returns (SoR) risk refers to the danger of encountering negative investment returns at the start of a retirement portfolio withdrawal period. To illustrate, imagine two retirees with identical portfolios and retirement income streams. However, the first retiree experiences a 10% annual investment loss in the first few years of retirement, while the second retiree enjoys 10% annual market gains for the same period. The first retiree, thanks to SoR risk, has a higher probability of running out of money more quickly than the second retiree.
So how can you manage SoR risk when planning for retirement? Here are some strategies to help protect your retirement savings:
1. Diversify your portfolio
Diversification is a common thread among most investment strategies, but it’s particularly applicable to SoR risk management. By diversifying your portfolio across a range of asset classes, you can reduce your risk exposure to any single investment. A diverse portfolio can help smooth out volatility, which can in turn reduce the risk of encountering negative returns during your retirement years.
2. Maintain a cash reserve
Retirees should also consider keeping a portion of their portfolio in cash or liquid assets to help manage SoR risk. By having a cash reserve on hand, you can draw from it during periods of market volatility instead of resorting to selling investments that may be down. Keeping a cash cushion allows you to weather the storm during more volatile periods and avoid tapping into your retirement account when its value has decreased.
3. Apply dynamic withdrawal strategies
Traditional retirement withdrawal strategies have centered on a static approach – with this mindset, retirees often withdraw a fixed percentage of their portfolio balance each year. However, this withdrawal approach does not take into consideration the unpredictable nature of the markets. Applying a dynamic withdrawal strategy can help mitigate SoR risk by adjusting withdrawals based on market conditions. Retirees can help avoid underspending during market booms or overspending during market crashes.
4. Consider incorporating guaranteed income
Guaranteed income is another way to help mitigate SoR risk. An annuity or pension can provide a baseline of income that a retiree can count on, regardless of the performance of their investment portfolio. This approach provides added stability and consistency in retirement. By combining a guaranteed income stream with a well-diversified portfolio, retirees can help reduce the risk of running out of savings.
5. Revisit your risk tolerance
Finally, it’s essential to revisit your risk tolerance when transitioning to retirement. As we age, our investment strategies should shift accordingly, as our risk tolerance often decreases over time. Work with a financial advisor to reassess your risk exposure and adjust your investment allocations if needed.
In conclusion, SoR risk is a real and often overlooked danger to retirees’ financial security. By diversifying your portfolio, maintaining a cash reserve, applying dynamic withdrawal strategies, incorporating guaranteed income, and reassessing your risk tolerance, you can help manage this risk more effectively. A well-planned retirement strategy can help ensure that you enjoy your golden years to the fullest, while minimizing the potential of running out of money.