Those who are retiring now might have waited too long. Don’t let this happen to you.
You might be thinking retirement is too far away to worry about. If you plan on claiming your gold watch within the next ten years, it’s not. In fact, if your last day is less than five years away, you’d better hurry. The clock is already ticking. Don’t put off until tomorrow what you should be doing today.
“When it comes to facing retirement, one of the biggest risks to one’s retirement nest egg is the sequence of investment returns,” says Adam Pawloski, Financial Life Advisor at Telemus Capital in Southfield, Michigan. “In a worst-case scenario, you are met with steep declines in your portfolio value right when you begin to live off of your investment assets. This results in locking in losses and reducing your war chest for future withdrawals.”
As you approach retirement, now is the time to consider how vulnerable you are to this sequence of returns risk. This is not the kind of risk you can maneuver to escape. It’s more or less random. The most you can do is inoculate yourself to avoid its worst effects.
“The sequence of returns risk is the simple risk of bad luck and bad timing,” says Brian Haney, Founder of The Haney Company located in Silver Spring, Maryland. “Since none of us knows when the next market decline is scheduled to occur, it’s virtually impossible to not face this as a risk when you are on the doorstep of retirement or have just recently retired. The risk itself is simple: having a major market decline that reduces the value of your retirement funds considerably right when you were preparing to start taking money out. What happens when you start making income withdrawals when your account value is down significantly, well…you lock in losses making recovery significantly harder than if you’d started taking withdrawals at a time when your account value was higher.”
There are a limited number of options should you find yourself suffering from the sequence of return risk during the onset of retirement. Many consider them less than desirable. They tend to defeat the purpose of “living the good life” in retirement.
To prevent this conundrum, you’d best start thinking about it now, well before you retire. Here, the options are not only much more palatable, but they’re also actually easier to implement and achieve.
“One of the easiest ways is to remove money that you intend on spending in the first few years of retirement out of the stock market,” says Sam Zimmerman, CEO of Sagewell Financial in Cambridge, Massachusetts.
“Having a short-term reserve to draw from is a good way to mitigate the risk,” says Shawn Plummer, CEO of The Annuity Expert, in Atlanta. “Basically, you want to avoid having to sell your investments in a market downturn, since those investments are likely to rebound in the near-to-medium term. With cash or other liquid investments available, you can essentially wait out the sequence of returns risk.”
Most financial professionals are aware of this tactic. “To minimize the impact of negatively sequenced returns, we typically de-risk clients’ portfolios as they near retirement,” says Michael Fischer, Director and Wealth Advisor at Round Table Wealth Management in Westfield, New Jersey. “The objective is to avoid or minimize large market drawdowns within the first few years of retirement so that the portfolio you have worked hard and saved hard to achieve can support the lifestyle you had anticipated in retirement.”
Do you want to know why so many first-year retirees have been caught by surprise with this current bout of sequence of return risk? It’s because when the market was going up like it had been since the recession of 2008/2009, (with a slight hiccup in March of 2020), people thought cash was a bad investment. Even today, with inflation hitting multi-generational highs, people are still worried about the “danger” of cash.
Here’s something to remember: the purpose of this tactic is to protect you on the downside, not to surpass any upside hurdles. In other words, you’re not aiming to earn any bragging rights. You just want to make your life more at ease.
“Maintaining ample cash and cash equivalents is a prudent way to minimize the impact of the sequence of returns risk,” says Tyler Papaz, Director of Private Wealth at Cornerstone Advisors Asset Management in Bethlehem, Pennsylvania. “This cash allocation may not outpace inflation, but it prevents investors from being forced sellers.”
More broadly, this specific tactic is merely a part of a comprehensive financial strategy. If you pay attention to the entirety of your life’s goals, this sort of thing naturally falls into place. It also makes you less concerned about “beating the market” and more interested in simply attaining your goals in life.
“The biggest thing you can do is make sure you have a financial plan,” says Scott Sturgeon, Founder & Senior Wealth Advisor at Oread Wealth Partners in Leawood, Kansas. “It doesn’t have to be anything fancy, but a rudimentary understanding of whether you’re living within your means, what your long-term cash flow looks like, and ensuring your investment portfolio and other assets are oriented to support your lifestyle in retirement.”
Even something as basic as a personal cash flow analysis will help you get a better grasp on things. It will also reveal how much cash you need to build up in your “emergency” fund by the time you retire.
“It is important to have a sound budget going into retirement to ensure that expenses in the early years don’t reduce the future earning power of the portfolio,” says Pawloski. “One strategy to minimize the impact is to have some cash set aside for the early withdrawals. Setting aside 12-18 months of cash can help to avoid selling at a market bottom.”
Also, you needn’t limit your definition of “cash” to a bank or money market account. It can be invested in other forms of securities, as long as the risk of capital loss or early withdrawal penalties can be diminished if not eliminated.
Rob Stevens, Financial Planning Thought Leader at TIAA in Charlotte, North Carolina, says, “It’s important to have ample cash reserves to cover expenses as you enter retirement as well as stable sources of income, such as guaranteed/stable value and/or individual bonds. Having stable sources of income gives retirees the flexibility to take distributions from equities when they want to rebalance rather than when they need to cover expenses.”
You may have heard of the period of five years before retirement referred to as “the Risk Zone.” The bottom line is the Risk Zone represents the time when you’re most exposed to extreme downside fluctuations in the market. Yes, there are ways to address it if this exposure is realized, but wouldn’t you be happier if you took steps to reduce this weakness before it occurs?
“Once a loss happens in the Risk Zone, you can try to go back to work and/or spend less,” says Ron Surz, President of Target Date Solutions in San Clemente California. “It’s best to guard against the loss in the first place. In other words, investors need to protect their savings in the Risk Zone.”
To repeat, it’s not like you have no options if you’re blindsided by the sequence of returns risk. The point is, while you have options, they’re not necessarily compatible with what you imagined retirement to be.
“Whenever a retiree is faced with the possibility of running out of money in retirement, for whatever reason, the harsh reality is usually to adjust your spending, or find a new source of income,” says Nicole Riney, VP, Financial Planner at Oak Harvest Financial Group in Houston. “For some, that means going back to work, for others, maybe you have to buy the cheap coffee for a while or skip that trip you had your heart set on.”
The best option, however, doesn’t present itself in retirement. It exists in those short years immediately before retirement. Those years give you time to prepare. They are a gift. And this is one gift horse you don’t want to look into the mouth of.