As you approach retirement, one of the biggest concerns you might face is ensuring your savings last throughout your retirement years. While you can control how much you save, the market’s performance is out of your hands, and negative returns during retirement can have a significant impact on the longevity of your savings. The sequence in which your investments earn returns—often referred to as “sequencing risk”—can be just as important as the overall average return.
What is Sequencing Risk?
Sequencing risk refers to the order in which your investments earn positive or negative returns. While negative returns in the market are an unfortunate reality, their timing can make all the difference to your financial stability in retirement. If you experience poor returns early in retirement, the money you withdraw may come from investments that have not had time to recover, which could significantly erode your savings. On the other hand, if the same negative returns occur later in retirement, your investments may have had time to recover, resulting in less impact on your overall portfolio.
Why is Sequencing Risk a Concern for Retirees?
Sequencing risk becomes especially critical as you near or enter retirement when your savings tend to be at their highest value. At this stage, you rely more heavily on these funds to support your lifestyle, and any large dips in the market can be harder to bounce back from. In addition, retirement typically involves regular withdrawals from your savings, which can compound the negative effects of a market downturn.
For example, it can take years for markets to recover from major losses, sometimes up to ten years or more. If you’re drawing from your retirement savings during this time, you may be selling investments at a loss, which prevents them from regaining their value. This is the essence of sequencing risk.
The Real Impact of Sequencing Risk
To illustrate how sequencing risk can affect retirees, let’s consider two investors who experience the same average returns over a 20-year period. Despite having identical average returns, one investor may run out of money sooner than the other. The key factor here is the timing of those returns.
A chart comparing the performance of a hypothetical retirement portfolio invested in 50% Australian equities and 50% bonds from 1992 to 2019 shows the difference sequencing risk can make. When the order of the returns is reversed—meaning poor returns happen at the beginning of the sequence—there’s a stark difference in how much the portfolio is worth at the end of the period. This demonstrates how critical the timing of returns is when you’re withdrawing money.
How Can You Manage Sequencing Risk?
While you cannot control the market’s performance or the sequence of returns, there are strategies you can use to protect your retirement savings from the impact of sequencing risk.
- Consult a Financial Adviser
One of the first steps you can take is to speak with a financial adviser to ensure you’re comfortable with your investment strategy and the level of risk you’re taking on. It might be worth reducing your exposure to the stock market, especially as you approach retirement, to limit the potential for negative returns during crucial years. - Diversify Your Income Sources
Consider complementing your retirement income with options that are not tied to the stock market. These could include annuities or other stable income streams that provide predictable returns, regardless of market fluctuations. - Implement a Bucketing Strategy
A bucketing strategy involves organizing your retirement savings into different “buckets” based on when you plan to use them. The idea is to have cash set aside in the short-term bucket so you don’t need to sell investments during a market downturn. The longer-term buckets would be invested more aggressively to provide growth over time. This strategy allows you to ride out market volatility without impacting your immediate income needs.
By adopting these strategies, you can reduce the impact of sequencing risk and increase the likelihood that your retirement savings will last throughout your retirement years.
Conclusion
Managing sequencing risk is an important part of retirement planning. Even though you can’t control market returns, you can control how you structure your retirement income and investment strategy to minimize the effects of negative returns. By diversifying your income sources, adjusting your investment approach, and consulting a financial adviser, you can ensure that your retirement is more secure and less vulnerable to market swings.
