When most people think about retirement, they imagine a time when they can finally relax and enjoy themselves after years of hard work. But for many retirees, the reality is far different. In fact, many retirees face a serious sequence risk that could have a devastating impact on their retirement income.
Sequence risk comes from a variety of factors, including market losses and inflation. In this guide, we will discuss some of the ways to protect against sequence risk and ensure a comfortable retirement.
1. What is sequence risk and why is it a problem for retirees?
Sequence risk is the risk of compounding market losses by taking income when the market is down. This can be a serious problem for retirees, who often have limited time to recover from market shortfalls - and may not have any other source of income.
This all comes back to how compounding interest works.
$1,000 that earns 10% will be worth $1100 at the end of the period.
The next year, I invest my $1100, again, it grows by 10%. At the end of the period, I have $1,210 (1100 x 1.1 = 1210).
The market does this each day. Each day, our investments go up or down. The growth we experience is based on our starting value.
Now, let's introduce a negative return. Let's say, instead of a +10% return, we had a negative 10% return, how would that affect us?
Year 1: $1,000, less 10% = $900
Year 2: $900, plus 10% = $990
Year 3: $990, plus 10% = $1,089
Total Return: 8.9%
This is basic math. We all know it. We've all experienced it.
But what happens if we are taking income during year one or year two? Let's say we are living on Social Security and we really need that extra $100 to pay our rent? We don't have a choice; we need the money. Let's see what happens:
Year 1: $1,000, less 10%, less $100 for rent = $900 - $100 for rent = $800
Year 2: $800 plus 10% = $880
Year 3: $880 plus 10% = $968
Total Return: -3.3%
If we look at the percent change in our portfolio value from year one to year two, not only did we experience the 10% market loss, but we suffered an additional 10% loss due to our withdrawal - for a net loss of 20%.
And these weren't paper losses either. The rest of the market didn't experience those losses. By drawing down our portfolio during a down market, we not only locked in the losses - we compounded them - and forever altered our retirement.
You can easily see the effect of sequence risk below:
2. The Hidden Dangers of Inflation and Sequence Risk
Inflation is often called "the silent thief" because it slowly erodes the value of your money without you even realizing it. While the effects of inflation may not be immediately apparent, over time, inflation can have a serious impact on your purchasing power.
For example, let's say you retire with a nest egg of $500,000. After 20 years of retirement, inflation has increased an average of 3% per year.
Assuming you don't make any withdrawals from your nest egg, at the end of 20 years, your $500,000 nest egg will be worth just $271,897 in today's dollars.
In other words, inflation has effectively stolen nearly $228,102 from your retirement savings.
The only way to combat inflation is by growing your assets faster than inflation. This can be difficult, especially if you are relying on income from investments that have a lower rate of return - while taking income from your portfolio.
If we adjust our market returns for inflation, this is what they look like:
Year 1: $1,000 -10% market loss -3% inflation -$100 rent = $770 buying power.
Year 2: $770 plus 10%, less 3% inflation = $826
Year 3: $826 plus 10%, less 3% inflation = $883
Total Return: -8.4% (was -3.3%)
If we look at the percent change of our portfolio value over the long run, we can see that while we may experience positive market returns, they are significantly lower when adjusted for inflation. This example is showing you a 3-year window, compound that out 15, 20, 30 years, and you will have a serious problem on your hands.
3. How to avoid sequence risk and protect your retirement income.
There is only one way to avoid sequence risk - and that is to avoid selling your investments during down markets. The issue is that we cannot know when there will be a down market, or how long it will last.
Here are some strategies advisors have come up with to address sequence risk. I would advise that you use one or more of these strategies in your retirement plan.
Build a Cash Cushion:
One way to protect yourself from sequence risk is to build a cash cushion. This will help you avoid having to sell investments during down markets. The FIRE (Financial Independence and Retire Early) movement is a big advocate of having a five-year cash cushion. If you could afford to have such a large cushion, that would be great. For most of us, that probably isn't realistic. But, even if you could save up a one-year cushion, that would help. The more of a buffer you have between you and your investments, the better off you will be.
Bucket or Time-banded Strategy:
Another way to protect yourself from sequence risk is to use a “bucket” or time-banded strategy. This approach involves dividing your assets into different buckets (or bands) according to when you plan to spend them. For example, you might have one bucket for short-term expenses (less than five years), one for intermediate-term expenses (five to ten years), and one for long-term expenses (more than ten years).
By using this strategy, you can avoid selling investments during down markets, since you will already have accessed the money in your short-term bucket. This approach also gives you some flexibility if you need to access money from a different bucket than you had originally planned.
The key to using this strategy is to make sure you are realistic about when you will need the money. You don't want to have all your money in a long-term bucket if you plan to retire sooner than expected.
This will help insulate you from the day-to-day noise of the market. However, you will still be impacted by an extended bear market or inflation.
The most common recommendation is to diversify. By diversifying your portfolio, you are spreading out the risk. This way, if one investment goes down, hopefully, the others will go up. This won't protect you from systemic risk, i.e., risks that affect the entire financial “system.” This can include things like a global pandemic, wars, or a major economic recession. But it can help protect you from individual stock or sector risk.
When diversifying, you want to make sure that your investments are “uncorrelated”, meaning they don't move in the same direction. This will increase the probability that when the market is tumbling, your uncorrelated assets will provide uplift and protection.
Of course, diversification comes at a cost, and it can't protect you 100%. In all likelihood, it will only reduce the magnitude of the losses.
Dividend Income Strategy:
Another way to protect your retirement income from sequence risk is to invest in dividend-paying stocks. Dividends provide a steady stream of income, which can help you ride out down markets. The more of your income you can derive from dividends, the more you'll be able to avoid selling during down markets and protect the long-term health of your retirement.
As an added bonus, during periods of high volatility, or high inflation, strong dividend stocks usually see a boost in performance as people flee to safety.
I think a dividend income strategy should be part of every retiree's portfolio.
Risk Transfer Strategies:
There are also a few risk transfer strategies that can help protect you from sequence risk. These include things like annuities, life insurance policies, and immediate fixed annuities.
These products can provide a guaranteed stream of income for a certain period of time. This can help reduce the impact of Sequence Risk on your retirement plan.
They can also have Cost-of-Living-Adjustments (COLAs) built in, which can help offset inflation risk.
The downside to these products is that they can be expensive, you usually have to give up some control over your money, and they aren't true investments. However, they can provide safety, peace of mind, guaranteed income for life, and ancillary benefits that may be worth the cost for some people. This is where consulting with a broker becomes critical.
When looking for insurance products, I recommend you work with a broker. A broker is someone who represents multiple companies and can shop around for the best policy for you. I would also recommend asking several insurance agents for quotes. Oftentimes, agents will represent different companies, or be familiar with different products, so getting two or three opinions can be beneficial in the long run.
Remember, insurance is not an investment. As with all things, read the fine print and understand what you are signing.
Another way to protect your retirement income from sequence risk is to use a dynamic withdrawal strategy. This involves taking out less money in down markets and more money when the market is up.
This will help you avoid selling stocks at low prices, which can further damage your portfolio. It also has the added benefit of allowing your portfolio to recover more quickly from market downturns.
The downside to this approach is that it means you will either have to reduce your lifestyle during down years or re-enter the workforce if that is still an option.
A dynamic withdrawal strategy is a good option for retirees who have “wiggle room” in their budget. It can also be a good option for retirees who are still working and have some income outside of their retirement portfolio.
4. Taxes, RMDs, and The Hidden Tax Bomb Buried in Your Retirement
You've probably heard the saying, "The two certainties in life are death and taxes." Unfortunately, when it comes to your retirement income, there is no escaping the taxman.
In addition to regular income taxes, you will also be subject to capital gains taxes on any withdrawals from your investment accounts. And, if you have money in traditional retirement accounts, like a 401k or IRA, you could be subject to required minimum distributions (RMDs).
“Required minimum distribution” is a rule that requires you to take a certain amount of money out of your retirement accounts each year. The RMD is based on your age, life expectancy, and the balance in your account at the beginning of the year.
The problem with RMDs is that they can add an extra layer of taxes to your retirement income and can actually push you into a higher tax bracket. It can trigger taxation on your Social Security benefits, which could put increased pressure on your portfolio.
Additionally, the taxes are due in the year you take your RMDs...and congress doesn't care if the market is down. So, while you may have done everything right to insulate yourself from sequence risk, the IRS may come knocking and force you to liquidate assets prematurely to pay an unwanted tax bill. (Oxymoron, “We’re from the government. We’re here to help you”)
In short, there are a lot of things to think about when it comes to retirement and taxes.
Some strategies you can employ to reduce your tax bill in retirement are tax-loss harvesting and strategic Roth conversions. Essentially, choose when and how to pay your taxes so you do it when it is advantageous to you (and not the IRS).
For a detailed guide on the subject, see my free guide: The Ultimate Guide to Paying Zero Percent in Taxes in Retirement.
Sequence risk, inflation, and taxes can be major threats to your retirement. However, with a little bit of foresight and planning, you can set yourself up for success.
Remember, it isn't about how much you make, but how much you keep that matters.
As always, if you have any questions or need help, don't hesitate to reach out. I'm here to help!
- All guarantees are based on the financial stability and claims paying ability of any issuing insurance company.
- All examples are hypothetical and used for illustration purposes only.
Get the answers you need! Fill out the form below and one of our coaches will answer.