Sequence-of-Returns Risk: What to Know
Why the order of your investment returns in early retirement can make or break your savings, and how a bucket strategy helps.
Summary
Ron Tallou warns that one of the most common retirement mistakes is withdrawing money without assessing how each holding has recently performed, and explains how a three-bucket strategy can protect income during a downturn.
Picture this: after years of hard work and diligent saving, you're finally ready to retire. But just as you begin withdrawing income from your portfolio, the market takes a sudden downturn. This unfortunate timing, known as sequence-of-returns risk, can have a significant impact on your financial future.
How sequence-of-returns risk works
Once you retire, it’s time to start drawing income from your accounts, such as a 401(k) or Roth IRA. Sequence-of-returns risk occurs when you begin making withdrawals during a market downturn, forcing you to sell investments at a loss and potentially shrinking your savings faster than you expected.
To imagine the impact, consider two retirees, A and B, who each retire with $2 million and plan to draw down $80,000 annually. Although they experience the same average annual return over a 30-year retirement, the sequence of those returns differs. Because Retiree B faces a downturn in the first few years and must sell investments at lower prices to fund withdrawals, their portfolio depletes more quickly overall.
When to start planning for it
Because sequence-of-returns risk is a serious threat to your retirement savings, it's important to begin planning for it as soon as possible. When you're younger and have a longer time horizon, it makes sense for your portfolio to comprise long-term growth assets such as equities. However, as you near your post-working days, this becomes risky.
Using a bucket strategy to protect your retirement income
One of the most common ways to guard against market downturns is the bucket strategy. It divides your retirement savings into three time-based categories: a short-term bucket that holds cash and near-liquid investments, a medium bucket that prioritizes modest growth via bonds or CDs, and a long-term bucket that allows you to invest in growth equities.
Mistakes to avoid
Ron Tallou, founder and owner of Tallou Financial Services, notes a common mistake he sees when clients are wanting to take money out of their accounts without assessing the recent performance of funds.
"They should be mindful of efficiently withdrawing money. This means looking at what the different holdings and accounts have done," Tallou says. If an asset experiences a drop in value, it’s often best to avoid selling it until it rebounds.
How a financial advisor can help
Planning for sequence-of-returns risk requires careful portfolio oversight and attention to market behavior. A professional can help you determine what your income needs will be in retirement, and use that to inform how much to keep in each bucket. Beyond the numbers, a high-quality advisor should keep you grounded and calm as you enter retirement.