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The start of retirement is an exciting time.
For years, you worked and perhaps raised a family while always keeping an eye on the future.
You consistently set aside money, with the express purpose of funding your lifestyle during your golden years.
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Now, with retirement near, or if it’s already begun, you’re ready to put those investments to use for both necessities and cherished bucket list items.
But all investments carry some degree of risk. They can lose value, sometimes significantly, when markets fluctuate.
When you’re young, with years of investing ahead of you, it can be easier to take those losses in stride. You know you’ll likely recover them over time.
But when the market experiences a substantial decline, the outcome can be quite different for those nearing or just beginning retirement. Once you stop contributing to investment accounts and start taking distributions, it can be harder to recover from a big loss.
A portfolio that was supposed to help provide income for a long retirement could come up short.
The possibility that ill-timed market declines could affect the longevity of your nest egg is known as sequence of returns risk, which can pose a serious threat to retirement success.
What is sequence of returns risk?
Sequence of returns risk is the danger that poor investment returns early in retirement, combined with regular withdrawals, can deplete your portfolio much faster than anticipated.
Even if your long-term average return reflects a solid performance, early losses could mean you’ll have to sell assets at a lower value, reducing the size of your portfolio and limiting your ability to recover when the market rebounds.
No one can predict what the market will do from one week to the next, much less in the years ahead. This means that two retirees with identical portfolios and withdrawal strategies could experience substantially different outcomes based solely on the sequence of returns they encounter at the time they choose to retire.
The chart shows how the sequence of returns could affect two hypothetical retirees with the same $1 million portfolio (fully invested in the S&P 500 index) and a $75,000 annual withdrawal rate. The striking difference in their balances after 10 years illustrates the challenge that sequence of returns risk presents.
Note: These hypothetical examples are provided for illustrative purposes only. Source: finance.yahoo.com
How can you avoid this?
The worst way to deal with sequence of returns risk is to cross your fingers and hope that the market will stay strong, or at least stable, at the start of your retirement.
Winging it is not the way to go, and it could make matters worse if you make decisions based not on sound planning but on emotions, such as denial, fear or despair.
Preparing for the possibility that the market could decline at just the wrong time is critical. That means building plenty of flexibility into your plan so you don’t become locked into taking portfolio withdrawals that require selling at a loss. Some strategies that can give you that flexibility include:
Drawing from safety assets
Pulling from cash reserves, short-term bonds or other safety assets can give your riskier assets time to recover from a loss.
The tricky part is deciding what portion of your investment should be parked in safety vehicles.
During employment, the general rule is to keep three to six months of income in liquid investments, but in retirement, that might not be a sustainable strategy.
If the markets were to rebound fairly quickly, as they did after the 2020 COVID-19-related crash, you’d be OK. But your money likely wouldn’t last through a longer slump, such as the 2008 financial crisis.
You might want to look at a “bucket” strategy that allocates funds for use during specific (short-, mid- and long-term) phases of your retirement. A knowledgeable financial adviser can help you determine what your income plan requires and how to invest with both safety and growth in mind.
Implementing an efficient withdrawal strategy
When multiple accounts are available, tax-savvy retirees typically draw from their taxable assets first, then tax-deferred accounts (401(k), 403(b), traditional IRA, etc.) and finally, their Roth accounts. But diverging from this strategy during a market downturn could help you prevent losses from affecting your overall retirement outlook.
Accessing funds from a tax-free Roth account during a downturn might help you manage tax bracket creep, reduce tax exposure and avoid triggering the Medicare IRMAA surcharge and potential taxes on a portion of your Social Security benefits, keeping more money in your pocket.
This strategy can also allow your tax-deferred assets to recover and preserve your traditional IRA for future growth.
Coordinating withdrawals with Social Security
The market has no impact on Social Security benefits, making these a reliable income source. When you choose to claim those benefits is an essential part of retirement planning.
If the market is strong, and you can get the income you need from your investment gains, you might decide to delay filing for Social Security. But claiming your benefits sooner might make sense during a down year if it helps you reduce withdrawals from your investments.
It’s definitely worth running the numbers for various scenarios so you understand your options.
Proactively managing RMDs
These required withdrawals can force retirees to sell assets during a market downturn, potentially locking in losses.
Proactively allocating a portion of your tax-deferred accounts to safety assets is one way to prepare for this potential pitfall.
Another is to take your distributions during market highs instead of on a predetermined, inflexible schedule.
You might want to consider the benefits of completing a Roth conversion before you reach the age at which RMDs become a factor.
Better prepared than scared
Experiencing a market downturn early in retirement can be damaging, but it doesn’t have to ruin your future. If you’ve recently retired or are close to retirement, there are steps you can take to preserve the longevity of your nest egg.
The sooner you make the necessary adjustments, the better off you’ll be. Don’t hesitate to ask for professional guidance if you need help evaluating the various strategies that can protect you and your family.
Kim Franke-Folstad contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
