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Beginning Badly

Richard Connor

SEQUENCE-OF-RETURN risk has long been a major concern among retirees—and it’s a real danger right now for those who just quit the workforce or soon will. Also known simply as sequence risk, it refers to the chance that the market declines sharply, forcing retirees to sell investments at depressed prices to generate income.

Wade Pfau, a leading retirement researcher, published a paper highlighting the danger involved. As he makes clear, a few years of market losses coupled with portfolio withdrawals can decimate savings, increasing the risk that a retiree will run out of money.

You might view sequence-of-return risk as the opposite of dollar-cost averaging. Instead of buying more shares when stock prices are down, you’re selling additional shares at lower prices to generate the same amount of income.

This year, unfortunately, provides a good example of how market forces can affect retirees’ savings—and their plans. Consider a retired couple with a $1 million portfolio who need $50,000 a year from savings to cover their expenses.

If they withdraw $50,000 at the beginning of the year, their balance is reduced to $950,000. If the stock market returned 10% that year, their balance at the end of the year would be $1,045,000. If this continued year after year, the retired couple would be in great shape. By the end of the fifth year, their balance would be $1,274,370.

But what if the market declined 10% in the year when they made their initial withdrawal? At the end of that first year, just as the couple was about to withdraw another $50,000, their balance would be $855,000. What if this continued? At the end of five years, their balance would be slashed by nearly 60%, to $406,211.

Folks who retired during the 2008-09 Great Recession encountered this risk head-on. I had a colleague who reached retirement age in 2007. He had changed employers several times in his career, so—unlike many of his coworkers—he didn’t have a significant pension. He also had major education expenses, including putting a daughter through medical school.

His plan was to work for as long as possible, continuing to save and invest. He also planned to postpone claiming Social Security so his benefit would grow in value. Unfortunately, the NASA program he was working on was canceled in 2008, eliminating his job. It was a stressful time for my colleague. Fortunately, after a few months, he was able to find a new job and continued working into his 70s.

Today, my wife and I are also confronting sequence-of-return risk. My wife retired last year, so 2022 is our first year with limited earned income. I have a pension that covers a good portion of our annual expenses, but we expected to dip into our retirement savings for the discretionary extras. Over the past two years, we’ve also undertaken several major home renovations.

We’d planned for these expenses by holding a large amount of cash, equal to about three years of discretionary expenses. The renovations ate up about two years of this money. This worries me some, but I remind myself that this is why we worked hard and saved all those years.

When we both claim Social Security in about five years, the combination of my pension plus our Social Security benefits should easily cover our expenses, as well as the extras—travel, gifts, entertainment—that make for a pleasant retirement.

How can we counteract sequence-of-return risk? The hope, of course, is that the market turns around and starts on its next bull run. But if luck isn’t with us, here are five ways to structure retirement income to lessen sequence risk’s corrosive effect:

1. Annuitize. If you’re lucky enough to have a defined benefit pension, you have a guaranteed stream of income. You get paid no matter what the market does. If you don’t have a pension, you can create an equivalent version by purchasing income annuities. This transfers investment risk from you to the insurance company.

2. Cash bucket. This is a popular strategy, one that my wife and I are using. It hinges on the notion that the stock market rebounds within a reasonable period of time. If you have enough cash to cover, say, three or five years of expenses, you can weather the market’s down years—usually.

3. Reduce spending. You might trim or delay large purchases. For many, tightening their belt comes naturally during a market downturn. But during the current market swoon, it’s been made more difficult by today’s high inflation. Recall the example above, where our hypothetical couple withdrew $50,000 a year. For next year, they might need more like $55,000 just to keep up with rising costs.

4. Work. For many retirees, a second career or part-time work can fill idle hours and provide welcome income. This can reduce or—if you’re industrious enough—even eliminate the need to sell investments in a down market. Indeed, it’s a strategy I’m considering. I’m currently looking at a few consulting opportunities.

5. Social Security. Some retirees plan to delay claiming Social Security until age 70 to maximize their benefit. If your retirement nest egg is getting scrambled by a prolonged market slump, you might opt to claim Social Security earlier and thereby reduce portfolio withdrawals.

Part of my angst about retiring into a down market is that I simply hate tapping our hard-earned retirement savings, especially at reduced valuations. But as I keep telling myself, why did we save all this money if not to fund our retirement? I doubt I’ll ever stop worrying completely, but I’m getting more comfortable with this “decumulation” phase.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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