The reason is not just how much their investments earn. It is also when gains and losses occur relative to their withdrawals.
That problem is known as sequence-of-returns risk.
Why withdrawals change the math
While you are still working and adding money to an investment account, a market decline can be uncomfortable. But if you are not selling investments to fund your lifestyle, the shares you own remain available to participate in a future recovery.
Retirement changes that equation. Once you begin taking regular withdrawals, a decline may force you to sell investments after their values have fallen. Those shares are no longer in the account if the market later recovers. The combination of a lower account value and continued withdrawals can make an early loss more damaging than the same loss occurring much later.
This does not mean every retiree should avoid investing or move everything to cash. It means a retirement-income plan should account for the order in which returns may arrive—not merely assume that a long-term average will show up smoothly each year.
What makes sequence risk more serious?
The effect varies from one household to another. Important factors include:
- how much of your spending must come from investments;
- the size and timing of withdrawals;
- whether spending can be adjusted temporarily;
- the mix of stocks, bonds, cash, and other investments;
- income from Social Security, pensions, work, or other sources;
- taxes and the types of accounts from which withdrawals are taken; and
- how long the money may need to last.
A person whose essential expenses are largely covered by reliable income may have more flexibility than someone who must fund nearly every expense from a volatile portfolio. Likewise, a household with room to delay a large discretionary purchase may be able to respond differently to a market decline than one with fixed near-term obligations.
Ways to plan for the risk
There is no single strategy that is right for every retiree, but a thoughtful plan may consider several tools.
Match near-term spending with appropriate assets
Money that is expected to be spent soon generally should not be treated exactly like money intended for much later in retirement. Separating near-term needs from longer-term investments may reduce the chance that every withdrawal depends on selling a volatile asset at an unfavorable time.
Holding more cash or short-term investments has limitations, however. These assets may earn less, lose purchasing power to inflation, or reduce the portfolio’s long-term growth potential. The appropriate amount depends on the household’s needs and circumstances.
Build flexibility into withdrawals
Some spending is essential; some is adjustable. Identifying that difference before a downturn can make decisions easier under pressure. A plan might establish rules for temporarily slowing discretionary withdrawals, postponing a major purchase, or using a different income source when markets are weak.
Flexibility can help manage risk, but it is not available to everyone. A retirement plan should not assume that basic living expenses can simply be cut whenever markets decline.
Diversify and rebalance intentionally
Diversification can reduce dependence on any one investment or type of risk, although it cannot prevent losses or guarantee a particular outcome. Rebalancing may also create a disciplined process for deciding what to sell rather than making the decision solely in response to recent performance.
Coordinate the entire income plan
Portfolio withdrawals should be considered alongside Social Security, pensions, taxes, required minimum distributions, insurance, and estate goals. A decision that reduces investment risk may create a different tax or liquidity tradeoff. Retirement income works best as one coordinated plan, not a collection of unrelated account decisions.
The bottom line
Retirement planning is not only about reaching a target account balance. It is also about deciding how that money will support spending through markets that will not move in a straight line.
The future sequence of returns cannot be known in advance. A useful plan acknowledges that uncertainty, identifies the decisions that can be controlled, and creates room to adjust when conditions change.
If you would like help reviewing how your investments and withdrawals fit together, contact WMS Group.
Important information: This material is for general educational purposes only and is not individualized investment, tax, or legal advice. Investing involves risk, including possible loss of principal. Diversification and planning strategies cannot guarantee a profit, prevent a loss, or ensure that retirement assets will last. Consult appropriate professionals about your circumstances.
