How to Mitigate Sequence of Returns Risk in Retirement

Sequence of returns risk challenges individuals nearing or in retirement, as the timing of investment returns profoundly impacts portfolio sustainability. It highlights that not just average returns matter, but when negative returns occur. When poor market performance happens early in retirement, individuals withdraw from a diminished portfolio, accelerating savings depletion. This severely impacts fund longevity, even if the market eventually recovers.

Retirees face a dilemma: they withdraw income while relying on investments to grow. Unlike the accumulation phase where downturns present buying opportunities, in retirement, negative returns necessitate selling more assets to meet living expenses, leaving fewer to benefit from subsequent recoveries. This dynamic makes managing sequence of returns risk central to retirement planning, emphasizing strategies for both investment growth and income stability.

Strategic Asset Management

Managing an investment portfolio is a primary method for mitigating sequence of returns risk. A foundational strategy involves diversifying investments across various asset classes: stocks, bonds, cash, and potentially real estate. Diversification helps distribute risk, as different asset classes often perform differently under varying market conditions, leading to a smoother return profile and reducing the impact of a downturn.

Beyond broad diversification, establishing an asset allocation tailored to one’s proximity to and duration of retirement is crucial. For those in early retirement, a more conservative allocation, perhaps with a higher weighting in bonds or cash, provides a buffer against immediate market volatility. Maintaining some exposure to growth-oriented assets remains important for long-term portfolio longevity, but this initial conservatism helps protect the portfolio’s value during the most vulnerable period when withdrawals begin.

Periodic rebalancing is an active management technique that maintains the desired asset allocation. This process involves selling assets that have performed well and grown to represent a larger portfolio portion, then using proceeds to purchase underperforming assets. Rebalancing helps ensure the portfolio does not become overly concentrated in risky assets during bull markets and systematically “locks in” gains, managing risk and potentially enhancing returns.

Flexible Income Approaches

Implementing flexible income approaches combats sequence of returns risk by adapting withdrawal amounts to prevailing market conditions. Dynamic withdrawal strategies adjust portfolio withdrawals based on performance. One popular example is the “guardrails” approach, setting upper and lower limits on withdrawal rates. Withdrawals might increase in strong market years and decrease in weaker ones, providing a responsive framework for managing income.

A common dynamic strategy involves a starting withdrawal rate (e.g., 4%) with annual adjustments based on portfolio value and inflation. If the portfolio performs well, withdrawals might increase; if it significantly declines, withdrawals are reduced to preserve capital. This adjustment prevents over-withdrawal during market downturns, allowing the portfolio more time to recover.

The cash bucket strategy holds a portion of living expenses (typically one to three years’ worth) in highly liquid, low-volatility assets like cash or short-term bonds. This “cash bucket” provides readily accessible funds, allowing retirees to avoid selling growth-oriented investments (e.g., stocks) during market downturns. This strategy provides a buffer, giving the portfolio time to recover before volatile assets need to be tapped for income.

Delaying Social Security benefits also serves as a flexible income approach, reducing immediate reliance on the investment portfolio. Individuals can begin collecting Social Security benefits as early as age 62, but delaying until full retirement age or up to age 70 significantly increases monthly benefits. For each year benefits are delayed past full retirement age (up to age 70), the monthly payment increases by approximately 6% to 8%, providing a larger, inflation-adjusted income stream.

Leveraging External Income Sources

Incorporating external income sources provides additional protection against sequence of returns risk, as these sources stabilize cash flow independently of investment portfolio performance. Certain types of annuities, such as immediate or deferred income annuities, offer guaranteed income streams for a set period or for life. These contracts with insurance companies provide predictable payments, covering essential living expenses and reducing the need to draw from a volatile investment portfolio during market declines.

For those with them, traditional defined-benefit pensions serve as a stable, external income source. Unlike investment portfolios, pension payments are typically fixed or adjusted for inflation, providing a reliable foundation for retirement expenses. This guaranteed income stream insulates retirees from market fluctuations, lessening the pressure to sell portfolio assets during unfavorable market conditions.

Engaging in part-time work or pursuing a phased retirement can also significantly mitigate risk. Continuing to work, even on a reduced schedule, provides earned income that can supplement or replace early portfolio withdrawals. This additional income allows the investment portfolio more time to grow or recover from market downturns without being subjected to significant withdrawals, thereby preserving capital and extending its longevity.