Early Retirement: How to Mitigate Sequence of Returns Risk

Sequence of returns risk poses a significant challenge to early retirees because the timing of withdrawals during market downturns can deplete savings more rapidly than withdrawals during more stable or growing markets. Here are some strategies to mitigate this risk:

• Create a Cash Reserve:
  • Maintain 2-3 years’ worth of living expenses in cash or a highly liquid account. This buffer can help you avoid withdrawing from investments during market downturns.
• Flexible Withdrawal Rate:
  • Adjust your withdrawal rate based on market performance. Reduce withdrawals during bear markets and withdraw more during bull markets. The “safe” initial withdrawal rate is generally considered to be around 4%, but flexibility helps.
• Dividend-Paying Stocks and Bonds:
  • By investing in stocks that pay dividends and bonds that generate interest income, you can create a steady income stream without needing to sell assets during market declines.
• Consider Annuities:
  • Annuities can provide a guaranteed income stream, which can be a good hedge against market volatility. However, they also come with drawbacks like fees and less liquidity, so careful consideration is required.
• Sequence Avoidance:
  • If feasible, avoid retiring or making large withdrawals from your portfolio during the first few years of a significant market downturn. Consider delaying significant expenditures until market conditions improve.

Now, let’s expand these points and review them in detail.

Understanding the Sequence of Returns Risk

Sequence of returns risk refers to the uncertainty of the timing of poor market performance. Even if the overall average returns over a long period are favorable, the order in which returns occur can significantly impact a retiree’s portfolio longevity. For instance, experiencing lower returns or losses in the initial years of retirement while withdrawing funds can erode a retirement portfolio rapidly, leaving less capital to recover during subsequent market upswings.

Two typical scenarios include: 

• Scenario A: You retire just before a market upturn. Even if the market later goes down, your portfolio has gained enough to withstand the downturn.
• Scenario B: You retire just before a market downturn. You start withdrawing from a shrinking portfolio, which may never recover.

To mitigate the sequence of returns risk, there are 4 common strategies.

1. Create a Cash Reserve:

Maintaining a cash reserve of 2-3 years’ worth of living expenses provides a strategic buffer against the sequence of returns risk. This reserve acts as a readily available source of funds, ensuring that retirees can meet their essential expenses without having to sell investments during market downturns. The concept is simple: By keeping a portion of your retirement savings in cash or highly liquid accounts, you create a financial safety net that mitigates the necessity of withdrawing from volatile investment accounts when market prices are low.

How to Establish and Manage a Cash Reserve

1. Determine Essential Expenses:

Calculate your annual living expenses, excluding any discretionary spending. Focus on mortgage or rent, utilities, food, healthcare, insurance, transportation, and other fixed costs. Multiplying this annual figure by 2-3 will give you the target cash reserve amount.

2. Choose the Right Accounts:

Opt for liquid accounts that offer easy access to funds. High-yield savings accounts, money market accounts, or even short-term certificates of deposit (CDs) are suitable options. These accounts often provide a balance between safety and modest returns, without tying up your money for long periods.

3. Automate Savings:

Build your cash reserve gradually by automating transfers from your income sources to your chosen liquid accounts. Regular, automated contributions can ease the burden of accumulating the necessary amount over time.

4. Reassess and Adjust:

Periodically review your cash reserve needs. Changes in your lifestyle, expenses, or market conditions may warrant adjustments to the amount you have set aside. Ensuring that your reserve remains aligned with your current situation is crucial for ongoing financial stability.

Advantages of Maintaining a Cash Reserve

1. Liquidity in Emergencies:

A cash reserve provides instant access to funds during emergencies, eliminating the need to prematurely sell investments. Whether it’s for unexpected medical expenses, urgent home repairs, or other unforeseen costs, having liquid assets on hand ensures peace of mind.

2. Avoiding Panic Selling:

During market downturns, it can be tempting to liquidate investments to cover living expenses. A cash reserve prevents panic selling, allowing you to stay invested and potentially benefit from future market recoveries. Selling in a bear market can lock in losses that may have otherwise been recouped over time.

3. Smoothing Portfolio Withdrawals:

Drawing from a cash reserve rather than directly from investment accounts ensures that you have a consistent income stream, regardless of market fluctuations. This smooths the sequence of withdrawals, reducing the impact of a poor sequence of returns on your overall financial health.

4. Flexibility for Strategic Financial Moves:

With a cash cushion, you can take advantage of market opportunities that arise during downturns. Having liquidity allows you the flexibility to make well-timed investment decisions, potentially acquiring undervalued assets that can enhance your portfolio’s long-term growth.

2.  Flexible Withdrawal Rate

For early retirees, managing the sequence of returns risk is critical, especially when reliance on a fixed income could be detrimental during market downturns. One effective strategy to mitigate this risk is adopting a flexible withdrawal rate. By adjusting withdrawals in response to market conditions, retirees can preserve their portfolios and enhance long-term financial security. This approach contrasts with the more rigid, traditional methods, like the widely accepted 4% withdrawal rule, offering retirees better control over their financial future.

Understanding the Standard 4% Rule

The 4% rule, developed in the 1990s by financial planner William Bengen, suggests that retirees can safely withdraw 4% of their retirement savings in the first year and adjust that amount annually for inflation. This strategy evolved from historical data analysis and was designed to ensure that retirees wouldn’t run out of money over a 30-year period. Although the rule provides a general guideline, it doesn’t account for fluctuating market conditions, which can impact the longevity and stability of retirement funds.

The Drawbacks of a Fixed Withdrawal Rate

1. Market Volatility:

Rigidly adhering to a fixed withdrawal rate during market downturns can exacerbate sequence of returns risk. When investment values are depressed, withdrawing a set percentage can significantly deplete the account balance, leaving less capital to recover when the market rebounds.

2. No Adaptability:

The 4% rule doesn’t accommodate changes in individual circumstances, such as increased medical expenses, significant lifestyle changes, or other financial needs that arise unexpectedly.

Benefits of a Flexible Withdrawal Rate

1. Enhanced Portfolio Longevity:

By reducing withdrawals during bear markets and increasing them during bull markets, retirees can preserve their portfolios’ principal during downturns and benefit more from market upswings. This approach helps to smooth out the impact of market volatility over time.

2. Adaptation to Personal Needs:

Flexible withdrawal strategies allow retirees to adjust their spending in response to changes in their personal and financial situations, providing better alignment with their actual needs and market realities.

3. Psychological Comfort:

Reducing withdrawals during market downturns can provide a psychological benefit, as retirees may feel more secure knowing they are preserving their nest egg rather than depleting it when markets are down.

Implementing a Flexible Withdrawal Strategy

1. Assess Market Conditions:

Regularly review and assess overall market performance and economic indicators. Having an understanding of market trends can help inform decisions on whether to increase or decrease withdrawal rates.

2. Set Baseline and Adjustments:

1. Start with a baseline withdrawal rate, such as the 4% rule, then adjust based on market performance. For example:
   1. During bull markets, consider increasing the withdrawal rate slightly (e.g., to 5-6%).
   2. During bear markets, reduce the withdrawal rate (e.g., to 3% or lower).
2. These adjustments should be carefully calculated based on your portfolio’s performance and your individual financial needs and goals.
3. Use a Guardrail Approach:

The guardrail strategy involves setting upper and lower limits (guardrails) on withdrawal rates relative to the portfolio’s value. If the portfolio value increases by a certain percentage above the baseline, increase withdrawals slightly. Conversely, if it drops below a set point, reduce withdrawals. This method provides a structured way to implement flexibility. Read more on  Best Withdrawal Strategies for Early Retirement

4. Income Bucketing:

Divide your retirement funds into different “buckets” based on time horizons and market conditions:

1. Short-term bucket: Cash or cash equivalents for immediate expenses (1-2 years).
2. Medium-term bucket: Bonds or other lower-risk investments for the next 3-7 years.
3. Long-term bucket: Equities and growth-focused investments for future needs (8+ years).

3.  Dividend-Paying Stocks and Bonds

Creating a sustainable and reliable income stream during retirement is a primary concern for retirees. One effective strategy to accomplish this goal involves investing in dividend-paying stocks and bonds. These assets can provide a steady flow of income without necessitating the liquidation of principal investments, thus helping retirees to better manage the sequence of returns risk and preserve their capital over the long term.

The Role of Dividend-Paying Stocks

Dividend-paying stocks are shares of companies that distribute a portion of their earnings to shareholders in the form of regular dividend payments. These stocks are generally associated with well-established, financially stable companies that have a history of generating consistent profits.

Advantages of Dividend-Paying Stocks:

1. Steady Income Stream:

Dividends provide regular income payments that can help cover living expenses without having to sell off investments, making them ideal for retirees seeking stability.

2. Capital Appreciation Potential:
   • In addition to providing dividend income, dividend-paying stocks have the potential for capital appreciation, as their value can grow over time, enhancing the overall growth of a retirement portfolio.
3. Inflation Hedge:

Companies that pay dividends often have pricing power that allows them to raise prices over time. This can help dividends keep pace with or exceed inflation, protecting the purchasing power of retirees’ income.

4. Financial Stability:

Companies that consistently pay dividends tend to be financially disciplined, stable, and less volatile compared to non-dividend-paying growth stocks. This makes them a safer choice for retirees who prioritize preserving capital.

Selecting Dividend-Paying Stocks:

1. Dividend Yield:

Look for stocks with a dividend yield that balances between providing sufficient income and maintaining growth potential. Yields that are too high may be unsustainable, while very low yields may not offer adequate income.

2. Dividend Growth History:

Focus on companies with a strong track record of consistent dividend payments and regular increases in dividend payouts. Dividend Aristocrats, companies that have increased their dividends for at least 25 consecutive years, are often considered reliable choices.

3. Payout Ratio:

Consider the payout ratio, which is the percentage of earnings paid out as dividends. A lower payout ratio indicates there is room for the company to increase dividends in the future, and it shows that the company retains earnings for growth and stability.

4. Sector Diversification:

Diversify across different sectors to reduce exposure to industry-specific risks. Sectors such as utilities, consumer staples, healthcare, and financials often include companies with strong dividend histories.

The Role of Bonds

Bonds are fixed-income securities that represent loans made by an investor to a borrower, typically corporate or governmental entities. Bonds pay periodic interest (coupon payments) and return the principal at maturity.

Advantages of Bonds:

1. Predictable Income:

Bonds provide a predictable and regular income stream through coupon payments, which can be particularly reliable during economic downturns when stock dividends might be cut or eliminated.

2. Inflation Hedge:

Bonds are generally less volatile than stocks and historically, bonds have outpaced inflation over the long term. This makes them a reliable investment for preserving purchasing power. 

3. Diversification:

Bond investments introduce diversification to a retirement portfolio, reducing overall volatility and helping to stabilize returns, especially when equities are underperforming.

Types of Bonds:

1. Government Bonds:

U.S. Treasury bonds, state and municipal bonds (munis), are considered safe investments with low risk of default, suitable for risk-averse retirees.

2. Corporate Bonds:

Bonds issued by companies tend to offer higher yields compared to government bonds but come with higher risk. Investment-grade corporate bonds balance income potential and risk.

3. High-Yield Bonds:

Also known as junk bonds, these offer higher yields but come with significantly higher risk. They can be part of a diversified strategy but should be approached with caution.

4. Bond Funds and ETFs:

These investment vehicles pool money from multiple investors to purchase a diversified portfolio of bonds, offering diversification and professional management.

Constructing a Dividend-Paying Stock and Bond Portfolio:

1. Determine Income Needs:

Calculate your expected annual living expenses and determine how much should come from investment income versus other sources (like Social Security or pensions).

2. Diversification:

Diversifying appropriately can help spread risks and optimize overall returns. For stocks, diversify across sectors and geographic regions. For bonds, diversify across issuers, maturities, and credit ratings.

3. Reinvest Dividends and Interest:

During the early years of retirement, consider reinvesting dividends and interest to grow your portfolio until you need to start withdrawing income.

4. Regular Rebalancing:

Periodically rebalance your portfolio to maintain your desired asset allocation and risk level. This involves buying or selling assets to bring your portfolio back in line with your target allocation.

4.   Consider Annuities 

Annuities offer the promise of guaranteed income, which can serve as a hedge against the uncertainties of the market. However, they come with their own set of complexities, including fees and liquidity constraints. This section will delve into the types of annuities, their benefits, drawbacks, and how to incorporate them into a well-rounded retirement strategy.

What Are Annuities?

Annuities are financial contracts between you and an insurance company designed to provide a steady income stream, typically for life. In exchange for a lump sum or periodic payments, the insurer promises to make regular payouts to you in the future.

Types of Annuities

1. Fixed Annuities:
   • Overview: Offer guaranteed fixed payouts.
   • Advantages: Predictable, stable income.
   • Drawbacks: The guaranteed rate might be lower than potential market returns.
2. Variable Annuities:
   • Overview: Payouts vary based on the performance of investment options chosen.
   • Advantages: Potential for higher returns.
   • Drawbacks: Exposure to market risk and typically higher fees.
3. Immediate Annuities:
   • Overview: Begin payments almost immediately after a lump sum payment.
   • Advantages: Quick income stream.
   • Drawbacks: Less time to grow your money, less liquidity.
4. Deferred Annuities:
   • Overview: Payments begin at a future date.
   • Advantages: More time for investment growth.
   • Drawbacks: Delayed access to income.
5. Indexed Annuities:
   • Overview: Returns are tied to a market index (e.g., S&P 500), but provide protection against market downturns.
   • Advantages: Potential for higher returns with limited downside risk.
   • Drawbacks: Often come with caps on returns and more complex fee structures.

Benefits of Annuities

1. Guaranteed Income:

A key benefit is the assurance of a steady income stream, irrespective of market conditions. This can provide peace of mind, knowing that you will receive regular payments for life.

2. Hedge Against Longevity Risk:

Annuities can protect against the risk of outliving your assets, ensuring that you have an income no matter how long you live.

3. Tax Advantages:

Earnings within an annuity grow tax-deferred, meaning you don’t pay taxes on the gains until you start receiving payments.

4. Customizable Options:

Annuities can be tailored with various features, such as inflation protection, survivor benefits, and guaranteed minimum withdrawals, to suit individual needs.

Drawbacks of Annuities

1. Fees and Expenses:

Annuities can come with high fees, including administrative fees, mortality and expense risk charges, and surrender charges. These can erode the overall returns of the annuity.

2. Lack of Liquidity:

Funds invested in annuities are generally locked up for a period of time. Early withdrawals may incur steep surrender charges, making them less accessible in emergencies.

3. Complexity:

The range of options and features can make annuities complex financial products. Understanding the terms and conditions requires careful consideration and often, professional guidance.

4. Credit Risk:

The guarantee of payments depends on the financial stability of the insurance company issuing the annuity. While the risk is generally low, it’s still an important factor to consider.

Incorporating Annuities into Retirement Planning

1. Evaluate Income Needs:

Determine how much of your retirement income should come from annuities. Consider covering essential expenses with fixed income sources like annuities, Social Security, and pensions.

2. Diversify Income Streams:

Annuities should be one part of a diversified retirement income strategy, which can also include investments in stocks, bonds, real estate, and other assets.

3. Start Small:

If you are new to annuities, consider starting with a smaller annuity to understand how it fits into your overall financial plan. You can always purchase additional annuities later.

4. Shop Around:

Compare products from different insurance companies. Look for annuities with favorable terms, lower fees, and strong financial ratings.

5. Consider Professional Advice:

Given the complexities and long-term implications of annuities, consulting with a financial advisor can be invaluable. They can help tailor an annuity strategy that aligns with your needs and goals.

6. Use Riders Thoughtfully:

Annuities can come with additional features known as riders, such as inflation protection or death benefits. While these can add value, they often come at an extra cost. Evaluate whether the rider benefits justify the additional expense.

7. Regular Reviews:

Continually review your annuity products and overall retirement plan. Changes in life circumstances, health, or financial goals may necessitate adjustments.

Case Study: Integrating Annuities into a Retirement Plan

Consider a 60-year-old retiree with a retirement portfolio of $1 million. They anticipate needing $50,000 annually for living expenses, excluding Social Security benefits.

Identify Essential Expenses: Calculate essential annual expenses, e.g., $40,000.

Allocate to Annuities: Decide to allocate $300,000 of the portfolio to a fixed immediate annuity, offering an annual payout of $15,000.

Balance with Other Investments: If Social Security is anticipated to cover $20,000 annually, only $5,000 remains to be covered from the investment portfolio, which can remain in more liquid and growth-oriented assets.

Incorporate Inflation Protection: Choose an inflation-protected annuity rider, ensuring the $15,000 payout adjusts with inflation.

Evaluate Fees and Terms: Assess the annuity fees and terms thoroughly before finalizing the purchase.

5. Sequence Avoidance

The timing of your withdrawals in retirement can significantly impact the longevity and health of your portfolio, especially if you encounter a market downturn early in your retirement years. This is where sequence of returns risk comes into play—a risk that your portfolio could suffer significant dips just as you start drawing down assets. To mitigate this risk, one strategy is sequence avoidance: specifically avoiding large withdrawals or even delaying retirement during the first few years of a significant market downturn. This section will explore the nuances of sequence avoidance and provide practical steps for its implementation.

Key Principles of Sequence Avoidance

1. Avoid Large Withdrawals During Downturns: Large withdrawals during a market lull can deplete your portfolio significantly. It’s better to withdraw minimally to ensure there are enough assets to grow when the market recovers.
2. Delay Significant Expenditures: Postpone large, discretionary expenses until market conditions improve. This includes luxury purchases, large home renovations, and other significant outlays that could strain your portfolio during a downturn.
3. Consider Delaying Retirement: If possible, delay your retirement if you see a significant market downturn approaching. Even working part-time can reduce the need to withdraw significant amounts from your portfolio.

Implementing Sequence Avoidance Strategies

Sequence avoidance strategies are integrated with all the previously mentioned strategies and more:

1. Build a Cash Reserve:

Maintain 2-3 years’ worth of essential living expenses in cash or cash-equivalent accounts. This ‘buffer’ can keep you from having to sell investments at a loss during downturns.

2. Flexible Withdrawal Strategy:

Instead of a fixed percentage withdrawal, adopt a flexible strategy that adjusts based on market performance. During bad years, withdraw less, and during good years, withdraw modestly more.

3. Stagger Retirements:

If you and your spouse are both planning to retire, consider staggering retirement dates. This allows one of you to remain in the workforce longer, providing additional income and potentially benefits like healthcare.

4. Part-Time Work or Gig Economy:

Explore opportunities for part-time work or gig economy jobs. This income can mitigate the need for large portfolio withdrawals during downturns.

5. Utilize Multiple Income Streams:

Diversify your income streams to reduce dependency on your investment portfolio. This could include rental income, royalties, pensions, and annuities.

6. Reevaluate Expenses:

Review and trim your expenses, especially discretionary ones, during market downturns. Focus on preserving capital and living within a more conservative budget temporarily.

7. Rebalance Your Portfolio: Regular rebalancing ensures your portfolio remains aligned with your risk tolerance and investment goals. This might also mean shifting more towards fixed income or dividend-paying stocks to balance out equity risk.
8. Tax-Efficient Withdrawals: Manage your withdrawals in a tax-efficient manner by drawing from taxable accounts first, followed by tax-deferred accounts, and lastly, tax-free accounts like Roth IRAs. This can help minimize taxes and extend the longevity of your portfolio.

Case Study: Successfully Implementing Sequence Avoidance

Let’s consider Jane and John, both 60, who plan to retire within the next year with a $1 million retirement portfolio. However, they face a significant market downturn just as they approach retirement. To navigate this challenging period, they take the following steps:

1. Creating a Cash Cushion:

They create a cash cushion with $150,000 in a high-yield savings account, covering their living expenses for the next three years.

2. Adjusting Their Retirement Plans:

John decides to continue working part-time for two more years to cover basic expenses and maintain employer healthcare benefits.

3. Flexible Withdrawal Strategy:

They adopt a flexible withdrawal strategy to minimize the impact on their portfolio. Instead of the planned 4% ($40,000 annually), they limit withdrawals to 3% during the downturn.

4. Rebalancing and Diversifying:

They rebalance their portfolio to maintain a 60/40 equity-to-bond allocation, ensuring a mix that is less susceptible to downturns.

5. Reducing Discretionary Spending:

Jane and John delay their planned $50,000 kitchen renovation and luxury cruise until market conditions improve.

6. Exploring Other Income Sources:

They rent out their vacation home for additional income, reducing their dependence on portfolio withdrawals.

Conclusion

By implementing these strategies, you can mitigate the sequence of returns risk and secure your financial future during retirement. Building a cash reserve, adopting a flexible withdrawal rate, utilizing dividend-paying stocks and bonds, and considering annuities are all prudent moves. Additionally, employing a bucket strategy, regularly rebalancing your portfolio, staggering retirement dates, and reducing expenses will further protect your retirement savings. With careful planning and adaptability, you can navigate market downturns and maintain financial stability throughout your retirement years.