Sequence of Return Risk: Eroding Retirement Withdrawals and Portfolio Longevity

Sequence of return risk stands as a critical, often underestimated, challenge to retirement income sustainability. It refers to the danger that the order in which investment returns occur significantly impacts the longevity of a retirement portfolio, particularly during the withdrawal phase. While average investment returns over a long period might appear adequate for a comfortable retirement, the sequence of those returns, especially in the early years of retirement, can dramatically alter the outcome, even with identical average returns over time.

To understand this risk, consider two hypothetical retirees with identical starting portfolios, withdrawal rates, and average investment returns over their retirement. However, their experiences diverge due to the sequence of returns. Retiree A experiences negative or low returns in the initial years of retirement, followed by strong positive returns later. Retiree B, conversely, enjoys strong positive returns early on, but then faces negative or low returns in the later years. Despite both experiencing the same average return over the entire period, Retiree A is far more likely to deplete their portfolio prematurely compared to Retiree B.

This disparity arises because withdrawals taken during periods of poor market performance force the retiree to sell a larger number of shares to meet their income needs. When markets subsequently recover, Retiree A has fewer shares remaining to benefit from the upswing. This erosion of the principal base early in retirement has a compounding negative effect. Conversely, Retiree B, who experiences positive returns early, benefits from portfolio growth in the initial years, creating a larger base from which to withstand potential downturns later in retirement. Even if later returns are less favorable, the portfolio has built a buffer, making it more resilient and sustainable.

The impact of sequence of return risk is amplified by several factors. Higher withdrawal rates naturally increase vulnerability. A retiree withdrawing a larger percentage of their portfolio annually has less margin for error and is more susceptible to early market downturns. Similarly, longer retirement durations extend the period over which sequence risk can manifest and exert its influence. Early retirement, therefore, while often desirable, can also increase exposure to this risk. Furthermore, less diversified portfolios, particularly those heavily weighted in volatile asset classes, are more prone to experiencing significant negative returns early in retirement, exacerbating sequence risk.

Mitigating sequence of return risk is paramount for ensuring retirement income sustainability. Strategies to consider include:

• Flexible Withdrawal Strategies: Rather than adhering to a fixed withdrawal amount, retirees can adopt flexible strategies that adjust withdrawals based on market performance. In years with negative returns, withdrawals could be reduced, if feasible, allowing the portfolio to recover. Conversely, withdrawals could be increased in years with strong positive returns.
• Asset Allocation Adjustments: Shifting towards a more conservative asset allocation in the years immediately preceding and following retirement can help cushion against early market downturns. This might involve increasing allocations to less volatile assets like bonds or cash equivalents, particularly in the early years of retirement.
• Bucketing Strategies: Dividing retirement savings into different “buckets” with varying time horizons and asset allocations can provide a buffer against sequence risk. A short-term bucket, funded with conservative investments, can cover immediate income needs, allowing longer-term buckets, invested more aggressively, time to recover from market downturns.
• Delaying Retirement (if possible): Working even a few years longer can significantly reduce sequence risk. It allows for continued portfolio accumulation, shortens the retirement duration, and potentially delays the onset of withdrawals to a period with more favorable market conditions.
• Considering Annuities: For a portion of retirement income, particularly essential expenses, retirees might consider purchasing immediate annuities. These provide guaranteed income streams, irrespective of market performance, thereby reducing reliance on portfolio withdrawals and mitigating sequence risk for a portion of their income needs.

In conclusion, sequence of return risk is a potent force that can undermine even well-laid retirement plans. Understanding its mechanics and proactively implementing mitigation strategies is crucial for retirees seeking to ensure their portfolios provide sustainable income throughout their retirement years. Ignoring this risk can lead to premature portfolio depletion, even with sound long-term average investment returns.