Sequence of Returns Risk: How to Protect Your Retirement During Market Crashes

One of the biggest concerns for retirees is the sequence of returns risk. This risk can
significantly impact how long your retirement savings last, especially during market
downturns. This article explains sequence of returns risk and provides strategies to protect
your retirement during market crashes.

Understanding Sequence of Returns Risk

Sequence of returns risk refers to the risk that the timing and order of your investment
returns can significantly affect your portfolio’s longevity. It’s particularly relevant
during the withdrawal phase of retirement.

Imagine two scenarios:

• Scenario A: You experience several years of poor returns early in
  retirement.
• Scenario B: You experience several years of poor returns later in
  retirement.

Even if the average return is the same over the entire period, Scenario A is much more
damaging. Early losses deplete your portfolio more quickly, leaving less money to benefit
from subsequent market recoveries.

Why Sequence of Returns Risk Matters in Retirement

During your working years, you’re contributing to your retirement accounts, so market
downturns have less impact. However, in retirement, you’re withdrawing funds, making the
sequence of returns critical.

Strategies to Protect Your Retirement

1. Diversification

A well-diversified portfolio helps mitigate sequence of returns risk.

• Asset Allocation: Invest in a mix of stocks, bonds, real estate, and
  other assets.
• Low Correlation Assets: Include assets that have low or negative
  correlation to the stock market.

2. The 4% Rule (with Caution)

The 4% rule (withdrawing 4% of your initial portfolio each year, adjusted for inflation)
can be a starting point, but it’s not foolproof.

• Flexibility: Be prepared to adjust your withdrawal rate if the
  market performs poorly.

3. The 3% Rule

A more conservative approach is to use the 3% rule, withdrawing only 3% of your initial
portfolio each year. This increases the likelihood of your savings lasting.

4. Cash Reserve

Maintain a cash reserve (e.g., 1-2 years’ worth of expenses) in a safe, liquid account.
This allows you to avoid selling investments during market downturns.

5. Bucketing Strategy

Divide your portfolio into “buckets” based on time horizons:

• Bucket 1 (1-2 years): Cash and short-term bonds.
• Bucket 2 (3-7 years): Intermediate-term bonds and balanced funds.
• Bucket 3 (7+ years): Stocks for long-term growth.

6. Dynamic Withdrawal Strategies

Adjust your withdrawals based on market performance.

• Percentage-Based Withdrawals: Withdraw a fixed percentage of your
  portfolio each year.
• Guardrails: Set upper and lower limits on your annual withdrawals.

Example

Suppose you retire with $1,000,000 and plan to withdraw 4% annually ($40,000).

• If you experience a 30% market decline in the first year, your portfolio drops to
  $700,000. Withdrawing $40,000 would significantly deplete your savings.
• A more conservative approach, like the 3% rule or flexible spending, would help
  mitigate this risk.

Conclusion

Sequence of returns risk is a significant concern for retirees. By diversifying your
portfolio, considering conservative withdrawal rates, maintaining a cash reserve, and
implementing dynamic withdrawal strategies, you can better protect your retirement savings
and navigate market volatility more confidently.

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Frequently Asked Questions (FAQ)