As retirement approaches, one of the most important concerns to address is how to safeguard your hard-earned savings from market volatility. In a recent conversation, John, a 52-year-old planning to retire at 55, raised concerns about sequence of return risk, a critical but often overlooked aspect of retirement planning. Like many of you, John is well-prepared for retirement in terms of his savings and financial strategy, but he remains apprehensive about how an early market downturn could impact his portfolio. In this post, we’ll explore what sequence of return risk is and how you can mitigate it to protect your wealth in retirement.
Understanding Sequence of Return Risk
One of the primary risks for retirees is the sequence in which market returns occur. While accumulating wealth during your working years, market downturns are less alarming because you’re still contributing to your investments and have time to recover from dips. However, once you start withdrawing from your retirement savings, especially during the early years of retirement, a market downturn can have a devastating effect on your portfolio’s longevity.
Consider this: if you retire at 55 and a bear market strikes during the first few years of retirement, your portfolio may suffer from having to sell investments at a loss to fund your withdrawals. Even if the average return over time is favorable, early losses combined with withdrawals can significantly deplete your savings.
For example, starting with $1 million in the year 2000, the market’s average return may have been a healthy 7.4% over the next decade, but a 5% annual withdrawal during early market downturns would have left your portfolio severely depleted by 2016. This is what’s known as sequence of return risk—it’s not just about how much your investments earn over time, but when they earn it.
John’s Retirement Strategy: Avoiding Sequence of Return Risk
John’s situation is not uncommon. Like many retirees, he has diligently saved and invested, and he is looking forward to an early retirement at 55, thanks to health insurance benefits from his employer. However, his portfolio is heavily invested in equities, which brings a higher potential for both growth and risk.
When we reviewed his portfolio, it was clear that while his overall savings are robust, the risk posed by market downturns at the start of his retirement could significantly impact his withdrawal strategy. We discussed two critical adjustments that could protect his savings from sequence of return risk:
1. Diversification
John’s portfolio is equity-heavy, meaning he’s heavily reliant on the stock market for his returns. While equities offer excellent growth potential, they also expose his portfolio to considerable risk, especially during periods of market volatility. Diversification is key to mitigating this risk.
Instead of concentrating his investments in the U.S. stock market (like the S&P 500), we explored diversifying into international markets, bonds, and other asset classes such as real estate investment trusts (REITs) or commodities. Diversifying doesn’t mean sacrificing returns—it means balancing growth with stability to ensure your portfolio can withstand market downturns.
While the returns from a diversified portfolio may be slightly lower than those from an all-equity portfolio during bull markets, the goal in retirement is not to chase the highest returns. The aim is to protect the wealth you’ve built. Diversification provides access to assets that may perform better during downturns, ensuring that you won’t be forced to sell stocks at a loss to fund your lifestyle.
2. Maintaining a Sustainable Withdrawal Strategy
A sustainable withdrawal strategy is another vital component of retirement planning. While John’s projected withdrawal rate is reasonable, we wanted to ensure it remained sustainable even in the event of an early market downturn.
We discussed keeping five years’ worth of living expenses in safer, more liquid assets such as bonds or cash. This approach provides a financial cushion during market downturns, allowing John to avoid selling growth assets (like stocks) at a loss to fund his retirement expenses. By keeping this buffer, he can wait for markets to recover before tapping into his equity investments again, preserving his portfolio’s long-term value.
The Role of Roth Conversions
John also expressed interest in Roth conversions as part of his retirement strategy. However, his high earnings have made it difficult for him to implement this strategy in recent years. Roth conversions can be an effective way to reduce your tax burden in retirement by moving money from tax-deferred accounts (like traditional IRAs or 401(k)s) into tax-free accounts (like Roth IRAs).
While the upfront tax bill for a Roth conversion may seem daunting, the long-term benefits—especially for high-income earners like John—can be substantial. Once the funds are in a Roth account, they grow tax-free, and withdrawals in retirement are also tax-free. This strategy can be particularly beneficial if you expect to be in a higher tax bracket later in retirement or if you want to leave a tax-free inheritance to your heirs.
Planning for Health and Longevity in Retirement
Beyond financial considerations, John’s retirement plans include staying active and engaged. He’s considering going back to school—possibly attending law school—and wants to volunteer his time as a pro-bono lawyer for those in need. These aspirations highlight an important aspect of retirement planning: it’s not just about money. It’s about having the freedom and resources to pursue passions and give back to the community.
Health is another critical factor for John. As someone with some existing health concerns, having access to quality medical insurance is paramount, especially during the gap between early retirement and when Medicare eligibility begins at 65. Planning for healthcare costs is an essential part of any retirement strategy, particularly for those retiring before they are eligible for Medicare.
Planning for a Secure and Fulfilling Retirement
John’s story illustrates a common concern for retirees: how to ensure your savings last throughout your retirement, regardless of what the markets do. Sequence of return risk is real, but with the right strategies—like diversification, maintaining a sustainable withdrawal rate, and considering tax-efficient moves like Roth conversions—you can protect your wealth and enjoy a financially secure retirement.
Retirement should be a time of opportunity, not worry. By planning ahead, you can ensure your portfolio is resilient, giving you the freedom to pursue your passions, whether that’s traveling, volunteering, or even going back to school.
