Why is sequencing risk a big deal for retirees?

Author: Jonathan Llewellyn | Financial Adviser | HFB Private Wealth

Here's why sequencing risk is particularly challenging for retirees:

1. Early Withdrawals During a Market Downturn:

• When you retire, you typically begin drawing from your investment accounts to cover your living expenses. If the market declines early in your retirement and you withdraw funds, you’re forced to sell investments at a lower value.
• This can be a double hit: not only is your portfolio shrinking due to market losses, but you're also depleting your funds faster by taking withdrawals during this downturn

2. Compounding Losses:

• Losses early in retirement can have a lasting effect because your portfolio has less time to recover. You may not have as many years for your investments to bounce back, which can compound the negative impact on your nest egg.
• For instance, if your portfolio decreases by 20% in the first year of retirement, you’d need a 25% gain just to get back to where you started. If you’re simultaneously withdrawing 4-5% per year, the recovery needed is even greater.

3. Longevity Risk:

• With people living longer, the risk of outliving your savings is real. Sequencing risk can accelerate the depletion of your retirement funds, increasing the chance that you'll run out of money later in life.

An Example to Illustrate Sequencing Risk

Imagine two retirees, Mary and John, who both retire with $1,000,000. They both plan to withdraw $50,000 per year for living expenses, adjusted for inflation.

• Mary retires at a time when the market performs well for the first few years, followed by a downturn.
• John retires when the market performs poorly initially but improves later on.

Even if the average annual return over 20 years is the same for both Mary and John, the order of returns drastically changes their outcomes. Mary may end up with more savings later in life, while John could run out of money earlier due to early negative returns. This illustrates that it’s not just how much you earn, but when you earn it, that matters.

How to Mitigate Sequencing Risk

While you can't control the market, there are strategies you can use to protect yourself from sequencing risk:

1. Maintain a Cash Reserve:

• Consider keeping 1-2 years' worth of living expenses in a safe, easily accessible account like a savings account. This can help you avoid withdrawing from your investment portfolio during a market downturn.

2. Consider a More Conservative Withdrawal Strategy:

• The "4% rule" (withdrawing 4% of your portfolio per year) is a common guideline, but flexibility is key. In years when the market is down, you might consider reducing your withdrawals temporarily.

3. Diversify Your Portfolio:

• Having a mix of assets (like stocks, bonds, and other investments) can reduce the overall volatility of your portfolio. A diversified portfolio may not be as vulnerable to the impact of a single market downturn.

4. Use a "Bucket" Approach:

• This strategy involves dividing your retirement savings into multiple "buckets" based on when you plan to use the money. For example:
• A short-term bucket (1-3 years) with cash or low-risk investments for immediate expenses.
• A medium-term bucket (4-7 years) with bonds or conservative investments.
• A long-term bucket (8+ years) with stocks for growth potential.

Final Thoughts

Understanding sequencing risk is crucial for retirees looking to preserve their savings and maintain their lifestyle throughout retirement. By planning ahead and using strategies to mitigate this risk, you can increase your chances of a financially secure retirement, regardless of market conditions.

Remember, the goal is to give yourself flexibility and resilience, so you’re not forced to make withdrawals at the worst possible times. By taking proactive steps, you can enjoy your retirement years with greater peace of mind.

General Advice Warning

The information contained in this communication is of a general nature only and does not take into account your personal financial situation, needs, or objectives. You should consider whether the information is appropriate to your specific circumstances before acting on it. We recommend seeking advice from a qualified financial adviser before making any financial decisions. The information provided is based on current laws and regulations, which are subject to change. Please note that past performance is not indicative of future results.