Our disciplined friend, whom we met in the previous article, tells us: “Thinking about my retirement, I have invested in a volatile portfolio, with an expected average annual return of 6%, higher than my projected annual withdrawal rate (4% of the initial amount, adjusted annually for inflation). Therefore, the withdrawals are sustainable, and I should not have any problems.”
Her reasoning would be correct under some assumptions: 1) the retirement period is not long enough for the value of the increasing annual withdrawals to be greater than the amount of the annual growth of the portfolio, which may eventually consume it; 2) inflation remains under control at low levels; and 3) the expected average return is not the result of a first few years of low performance, followed by years of high performance.
Of these assumptions, the one that can be of most concern to us is the third, because there is no reason why a recently retired person cannot experience several years of below-average long-term returns. A little bad luck would be enough!
This possibility is called Sequence Risk. In this situation, due to lower returns at the beginning, the portfolio would not be able to grow enough to sustain the larger withdrawals in the future. This negative effect would be reinforced by the fact that the assets that suffered the biggest price drops may have to be liquidated, so they will no longer be there when an eventual recovery comes. Sequence Risk can make the portfolio unable to sustain the required spending throughout retirement.
Sequence Risk can be mitigated in several ways. The first is by maintaining cash reserves that are ample enough so that you don’t have to touch the portfolio during the sharpest phases of the downturn. The second is liquidating those assets that have not fallen in price or that have fallen less so as not to limit the possibility of recovery. The third, and no less effective, is to reduce the level of expenditure during years of low returns.
Additionally, it is recommended to reach retirement with a mix of income sources that have different levels of exposure to market risks, ideally with some of them completely decoupled from the market. For the portion exposed to the market, the investment portfolios should be more balanced, that is, including assets that are not very volatile or that by their nature can counteract the declines of the most volatile assets.
A consultation with your financial advisor can help you better understand your level of exposure to sequence risk and establish strategies to mitigate it.
Sources: Sequence Risk During Retirement | Morningstar. Pfau, Wade. Retirement Planning Guidebook. Vienna, VA: Retirement Researcher Media, 2023.
Disclaimer: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax advice, as we do not provide tax or legal advice. Consult a tax professional to make sure the recommendations are appropriate for your situation.