Sequence of Returns Risk: Why a Market Crash in Retirement Is Different

Sequence of returns risk is the potential for the order in which you experience investment returns to have a significant, and potentially devastating, impact on the longevity of your retirement portfolio. While the average long-term return of your portfolio is important, the timing of those returns, especially in the early years of retirement, can make the difference between a comfortable and a stressful retirement.

Imagine two retirees, Linda and Robert, who both retire with a $1 million portfolio and plan to withdraw $40,000 a year for living expenses. Linda retires into a bull market, and her portfolio grows by 10% in her first year. Robert, on the other hand, retires just before a major market crash, and his portfolio loses 10% in his first year. Even if their average returns over the next 30 years are identical, Robert is at a much higher risk of running out of money. This is the essence of sequence of returns risk. The concept was first articulated by William Bengen, a financial advisor who conducted extensive research on safe withdrawal rates in retirement. His work, often referred to as the '4% rule,' highlighted the importance of the initial years of retirement and the dangers of a down market during this critical period.

The math behind portfolio recovery is unforgiving. A 10% loss requires an 11.1% gain to get back to even. A 20% loss needs a 25% gain. And a 50% loss requires a 100% gain. When you are withdrawing money from your portfolio to live on, the math gets even worse. Those withdrawals during a downturn act as a permanent drag on your portfolio, making it that much harder to recover.

This is not just a theoretical exercise. The emotional toll of seeing your retirement savings decline can lead to poor decision-making, such as selling at the bottom of the market and locking in your losses. Understanding the math of gains and losses is the first step to developing a retirement income plan that can withstand market volatility.

Most investors are familiar with dollar cost averaging, the strategy of investing a fixed amount of money at regular intervals, regardless of market fluctuations. This works in your favor during your accumulation years, as your fixed investment buys more shares when prices are low. However, in retirement, the opposite occurs, a phenomenon known as reverse dollar cost averaging.

When you withdraw a fixed amount of money from a declining portfolio, you are forced to sell more shares to generate the same amount of income. This depletes your portfolio more quickly and leaves you with fewer shares to benefit from a potential market recovery. It's a vicious cycle that can have a devastating impact on your retirement savings. This is why financial planners often recommend having a cash cushion to draw from during market downturns, to avoid selling stocks at a loss.

Let's go back to our two retirees, Linda and Robert. Both start with a $1 million portfolio and withdraw $40,000 in their first year of retirement. Linda's portfolio earns 10% in her first year, while Robert's loses 10%.

• Linda: Her portfolio grows to $1.1 million, and after her $40,000 withdrawal, she has $1,060,000.
• Robert: His portfolio drops to $900,000, and after his $40,000 withdrawal, he has $860,000.

Now, let's say that in the second year, the market returns to its average, and both Linda and Robert earn a 7% return. Linda's portfolio grows to $1,134,200, while Robert's only grows to $920,200. After just two years, Robert's portfolio is significantly smaller than Linda's, even though they both experienced the same average return over the two-year period. This illustrates the powerful and destructive nature of sequence of returns risk. Over a 30-year retirement, this initial difference can compound, leading to a situation where Robert may have to drastically reduce his spending or risk running out of money entirely, while Linda's portfolio continues to grow.

The financial impact of sequence of returns risk is significant, but the psychological toll can be just as damaging. Retiring into a bear market can be a deeply unsettling experience. After decades of saving and planning, to see your nest egg shrink just as you begin to rely on it can lead to anxiety, stress, and a loss of confidence in your financial future. This can lead to a number of negative behaviors, such as:

• Panic Selling: The fear of further losses can cause retirees to sell their investments at the worst possible time, locking in losses and making it impossible to benefit from a market recovery.
• Over-conservatism: After experiencing a market downturn, some retirees may become overly conservative with their investments, shifting to an all-cash or all-bond portfolio. While this may feel safer, it can lead to a different kind of risk: inflation risk, where the purchasing power of your savings is eroded over time.
• Reduced Spending: To preserve their capital, retirees may drastically cut back on their spending, forgoing travel, hobbies, and other activities they had planned for their retirement. This can lead to a diminished quality of life and a sense of regret.

It is important to have a financial plan that not only addresses the mathematical realities of sequence of returns risk but also provides a framework for making rational decisions during periods of market stress.

History has shown that market crashes are an inevitable part of investing. While the long-term trend of the market is upward, there have been numerous periods of significant decline. The recovery time from these crashes can vary widely. For example, the dot-com bubble burst in 2000 took years to recover from, while the COVID-19 crash in 2020 was followed by a surprisingly swift recovery. According to research from Morningstar, the average recovery period for major U.S. market crashes is about two years, though some have taken much longer. The Great Depression, for example, took 25 years for the Dow to recover to its pre-crash highs.

The problem for retirees is that they don't have the luxury of time to wait for a recovery. A prolonged bear market in the early years of retirement can be a knockout blow to a portfolio, even if the market eventually recovers. This is why Wade Pfau, a leading expert on retirement income, has written extensively about the importance of managing sequence of returns risk. His research has shown that the first ten years of retirement are the most critical. A poor sequence of returns during this period can have a much greater impact than a similar downturn later in retirement.

How can you know if your retirement plan is vulnerable to sequence of returns risk? One powerful tool is a Monte Carlo simulation. This is a computer-based simulation that runs thousands of possible market scenarios, using historical data to model a wide range of potential returns. By running these simulations, you can get a better sense of the probability of success for your retirement plan.

A Monte Carlo simulation can help you to answer questions like: What is the probability that my money will last for 30 years? What is the impact of a major market crash in the first few years of my retirement? How would my plan be affected if I delayed my retirement by a few years? While a Monte Carlo simulation cannot predict the future, it can be a valuable tool for understanding the potential risks and for making more informed decisions about your retirement. Many financial advisors use Monte Carlo simulations as a standard part of their retirement planning process.

Fortunately, there are strategies that retirees can employ to mitigate sequence of returns risk. These include:

• Asset Allocation: A well-diversified portfolio with a mix of stocks and bonds can help to cushion the blow of a market downturn. As you approach retirement, it may be prudent to shift your asset allocation to a more conservative mix. This might mean reducing your exposure to stocks and increasing your allocation to bonds and other less volatile assets.
• The Bucket Strategy: This strategy involves dividing your retirement assets into different "buckets" based on your time horizon. The first bucket would hold cash and other liquid assets to cover your living expenses for the first few years of retirement. The second bucket would hold a mix of stocks and bonds for intermediate-term growth, and the third bucket would be invested in more aggressive growth assets for the long term. The idea is to avoid selling stocks in a down market to cover your living expenses.
• Flexible Withdrawal Strategy: Instead of taking a fixed withdrawal each year, you could adjust your withdrawals based on market performance. In down years, you would withdraw less, and in up years, you could withdraw more. This can help to preserve your portfolio during market downturns and give it a better chance to recover. This is often referred to as a 'dynamic spending' or 'guardrail' strategy.

Annuities can play a valuable role in mitigating sequence of returns risk by providing a guaranteed stream of income for life. This can help to cover your essential expenses, regardless of what the market is doing. By having a portion of your retirement income secured, you can reduce your reliance on your investment portfolio, especially during market downturns.

There are many different types of annuities, each with its own features and benefits. For example, a single premium immediate annuity (SPIA) can provide a fixed income stream for life in exchange for a lump-sum premium. A fixed indexed annuity (FIA) offers the potential for growth based on the performance of a market index, while also providing protection from market downturns. It's important to work with a qualified financial advisor to determine if an annuity is right for you and, if so, which type of annuity best suits your needs. An annuity can provide peace of mind and a stable foundation for your retirement income plan, allowing you to weather market volatility with greater confidence.

This article is for educational purposes only and should not be considered financial, legal, or tax advice. Annuities are insurance products and are not insured by the FDIC or any federal government agency. Annuity guarantees are backed solely by the financial strength and claims-paying ability of the issuing insurance company. Retire Wizard is an annuity advisor matching service, not an insurance company. Consult a qualified financial advisor and tax professional for personalized guidance.