Many people and families who are getting close to retirement put a lot of effort into saving, investing, and getting ready for a stable financial future throughout the years. But even the best-laid financial strategies can be subtly undermined by one risk that is frequently disregarded: sequence of returns risk. This risk arises when a retiree's capacity to produce income from their portfolio is adversely impacted by the timing of market returns.
Sequence of Returns Risk: What is it?
Order of Returns: Anyone who depends on their investments for retirement income must take risk into account. It draws attention to a possible problem that can occur even with a sound financial plan: even if you save assiduously, make prudent investments, and plan your retirement precisely, a market decline early in your retirement may affect the recovery of your portfolio. Your future income may be reduced as a result, particularly if you have to sell investments at a loss to pay for bills.
The fundamental aspect of this risk is that, even if markets typically show an upward trend over time, the returns you receive in your early retirement years have a big impact on how your financial status turns out. Your portfolio's future potential can be significantly diminished by a subpar market return during the first few years of retirement, particularly if withdrawals are being made at the same time.
The Significance of Timing
The immediate effects that market downturns can have on retirees are not taken into consideration by the widespread belief that markets will rise over time. An investor is forced to sell assets at a loss when they start taking income from their retirement portfolio and the market declines. Because there are fewer assets available to recover and appreciate in value, this not only locks in those losses but also lowers the portfolio's potential to produce income in the future.
This problem isn't merely theoretical; there are actual cases where retirees have had trouble sticking to their financial objectives due to bad timing in their early retirement. In the initial years, poor timing can damage even portfolios that seem sound on paper. Early retirement income sustainability and future growth potential can be seriously hampered by a negative return.
The "Bucket" strategy is a more intelligent way to generate income.
It's crucial to design a retirement income plan that considers both the amount saved and the timing of fund access in order to mitigate the risk of sequence of returns. A strategy that separates retirement assets into many "buckets" or parts is what we at Wealth Enhancement Group advise. Each bucket has a distinct function and time horizon, assisting in making sure you have a steady source of income independent of stock market volatility.
This is how the tactic operates:
Bucket 1: Stability First, Years 1–5
The purpose of the first bucket is to give you the income you require during the first few years of retirement. Investments like cash reserves, certificates of deposit (CDs), short-term Treasuries, or fixed annuities are among its low-risk, highly liquid assets. Bucket 1's objective is predictability rather than growth, making sure you have the money you require at this critical time without having to worry about market swings.
Bucket 2: Moderate Growth with Purpose, Years 6–10
The second bucket concentrates on moderate growth, while the first bucket offers stability. Bonds, fixed annuities with income riders, and other conservative investment vehicles that mature in the second decade of retirement may be included in this section of your portfolio. With a focus on making sure the money is available when needed for future income demands, Bucket 2 is intended to grow in a way that permits moderate risk.
Bucket 3: Long-Term Growth and Volatility Management, Years 11–15
Bucket 3 is set up for long-term growth and is saved for eventual retirement years. Since a decade's worth of income needs have already been met by Buckets 1 and 2, this bucket may afford to include a bigger proportion of stocks, which may be more volatile in the short term but have higher growth potential. This bucket will eventually be able to bounce back from brief declines and have more time to expand, taking advantage of the markets' long-term rising trend.
Bucket 4 and Beyond: Legacy and Longevity in Years 16+
Bucket 4 is a long-term growth strategy that can concentrate largely on riskier investments with higher potential returns for people whose retirement plan is longer than 15 years. These funds may remain unaltered for many years, giving them time to grow and be utilized for legacy objectives, long-term care, or late retirement needs. Either by covering late retirement costs or by providing a legacy for future generations, they are meant to meet your financial demands in the far future.
The Bucket Strategy's Benefits
This method is successful because it prevents emotional decision-making, particularly when the market is volatile. Retirees might feel okay knowing that they have already set aside a portion of their assets for short-term income needs in the event of market volatility. This strategy gives your long-term growth assets the time they require to recover by eliminating the need to panic and sell investments during a slump.
In addition to providing for growth prospects in the later years of retirement, this structured income plan is designed so that seniors won't be reliant on market fluctuations for their daily living needs.
In conclusion
Making sure your savings last throughout your retirement years is the goal of retirement planning, not just saving enough money. Now is the ideal time to discuss developing a structured income plan with a fiduciary advisor if you are retiring or within five to ten years of retirement. With this plan, you may increase your financial future certainty and steer clear of the sequence of returns risk traps.
The approach described here is intended to provide you comfort, lessen the anxiety of responding to market swings, with the intention that your portfolio can weather both prosperous and challenging years. We at Wealth Enhancement Group collaborate with our clients to create prudent, well-thought-out retirement plans that will preserve their financial prospects while giving them the income they require to live comfortably in retirement.
Underestimating the significance of modifying their withdrawal strategy to adapt for inflation is one of the most common mistakes retirees make immediately following retirement. A study by Fidelity Investments (2023) suggests that retirees who do not account for inflation may find that their purchasing power declines as they age. It is crucial to incorporate inflation-adjusted solutions in retirement planning since even slight inflation over time can reduce the value of fixed withdrawals. Retirees can preserve their quality of life in spite of growing expenses by making plans for this.
Retirement might be compared to planning a lengthy road trip. You've packed your car, made sure it's in good shape, and meticulously planned your trip. But like a driver who forgets to check the fuel gauge, one of the biggest mistakes retirees make is to underestimate how important it is to modify their spending plan to take rising costs into account over time. Ignoring inflation can gradually reduce your purchasing power and make it more difficult to sustain your lifestyle, much like running out of fuel might cause your trip to go awry. A smoother journey into retirement is ensured by making plans for both the smooth roads and any unforeseen hiccups.