The phenomenon is known as **sequence-of-returns risk**. This risk can have a profound impact on your retirement savings, especially if you experience significant market downturns early in your retirement. Let's delve into this concept and explore strategies to mitigate the risk:
### Sequence-of-Returns Risk Explained
**Sequence-of-returns risk** refers to the order in which investment returns occur and how this order affects the longevity of your retirement portfolio. While the average return over a period might be the same, the sequence of those returns can dramatically affect the final outcome.
#### Example Scenario:
- **Investor 1**: Faces a 15% decline in the first two years of retirement.
- **Investor 2**: Faces a 15% decline in the 10th and 11th years of retirement.
Both investors start with $1 million, withdraw $50,000 annually (adjusted for 2% inflation each year), and experience a 6% return in non-decline years. Investor 1 runs out of money in 18 years, while Investor 2 still has nearly $400,000 left after 18 years.
### Strategies to Mitigate Sequence-of-Returns Risk
1. **Maintain a Cash Reserve**
- **Approach**: Keep a reserve of low-risk, liquid investments to cover expenses during market downturns.
- **Implementation**:
- Maintain one year's worth of expenses in cash investments.
- Hold another two to four years' worth of expenses in high-quality short-term bonds or bond funds.
2. **Diversify Your Portfolio**
- **Approach**: Ensure a mix of cash, bonds, and stocks to provide both income and growth.
- **Implementation**:
- Allocate a portion of your portfolio to cash and short-term bonds.
- Maintain a diversified portfolio that can weather different market conditions.
3. **Scale Back Withdrawals**
- **Approach**: Reduce the amount you withdraw from your portfolio during market downturns.
- **Implementation**:
- Consider temporarily reducing your withdrawal rate.
- Forego inflation adjustments or postpone large expenses.
4. **Adjust Withdrawal Strategies**
- **Approach**: Implement flexible withdrawal strategies that adjust based on market performance.
- **Implementation**:
- Use a percentage-based withdrawal strategy rather than a fixed dollar amount.
- Increase withdrawals in good years and decrease them in bad years.
5. **Bucket Strategy**
- **Approach**: Divide your portfolio into different "buckets" based on the time horizon.
- **Implementation**:
- Short-term bucket: Cash and short-term bonds for immediate expenses.
- Medium-term bucket: Bonds and income-producing assets for expenses in the next 5-10 years.
- Long-term bucket: Stocks and growth assets for expenses beyond 10 years.
### Hypothetical Example
#### Initial Setup:
- **Portfolio**: $1 million
- **Initial Withdrawal**: $50,000 annually (adjusted for 2% inflation)
- **Market Decline**: 15% in the first two years
- **Market Recovery**: 6% annual return thereafter
#### Two Scenarios:
- **Scenario 1**: Investor reduces withdrawals to 2% after a market drop.
- **Outcome**: Recovers original portfolio value in approximately 11.5 years.
- **Scenario 2**: Investor maintains a 4% withdrawal rate.
- **Outcome**: Requires 28 years of 6% annual returns to fully recover.
### Implementing the Strategies
1. **Build a Cash Reserve**:
- Calculate one year’s worth of living expenses.
- Allocate this amount to cash or cash-equivalent investments (e.g., money market funds).
2. **Diversify Investments**:
- Use a mix of equities, bonds, and other asset classes.
- Regularly rebalance the portfolio to maintain the desired asset allocation.
3. **Flexible Withdrawals**:
- Set a base withdrawal rate (e.g., 4%).
- Adjust the rate based on market performance and personal needs.
4. **Bucket Strategy**:
- Short-term: Allocate 1-2 years of expenses in cash.
- Medium-term: Invest in bonds or bond funds.
- Long-term: Keep a majority in stocks for growth.
By incorporating these strategies, you can better manage sequence-of-returns risk and enhance the sustainability of your retirement portfolio. Remember, the key is flexibility and preparation to handle various market conditions.
