Will your retirement savings be enough?
This question is enough to cause concern among many people. How much do you need to retire? With news media throwing around words like economic recession, these concerns also bring another element to consider, sequence risk.
Sequence risk is the danger posed by an economic downturn on an investment portfolio in the short term. While a recession provides an excellent opportunity to build wealth for a younger person, that same recession could greatly impact retirement accounts for those already in retirement or close to it. Simply put, sequence risk is the threat of withdrawing money in a downturn.
Despite an economic downturn, you still require money to live. Because of this, when your portfolio loses value, you need to withdraw more of it as a % of total to end up with the same benefits. Burning through your retirement portfolio too quickly can lead to more life at the end of your money, not a comfortable place to be in.
To illustrate, we’ll look at a retirement portfolio of $ 1 million, invested in stocks. (We’ll pretend like you didn’t read the asset allocation articles and didn’t realize that 100% invested in stocks is risky!) If you retired in 2008, your $ 1 million portfolio would have been hit with a loss of approximately 38%. That takes your portfolio down to $ 620,000, and you’ll still need to withdraw to pay for retirement! Those withdrawals are $ 50,000 in the first year of retirement, which is 8.06% of the portfolio!
If you had retired in 2011 instead, where the stock market virtually didn’t grow, with an average growth of approximately -0.00 %. A withdrawal of 50,000 from your $ 1 million nest egg would only be a withdrawal of 5%.
That is the impact of sequence risk, that you may be withdrawing more as a total % of your portfolio in a market downturn. Spending through your retirement savings too fast, even when the dollar amount doesn’t change, is something that is almost impossible to recover from.
How can you mitigate sequence risk?
Understanding what sequence risk is, and how it can impact your retirement savings allows you to create a financial strategy to mitigate the risk. There are many options available here, and anyone close to retirement would be wise to consider them.
More heavily weighting your portfolio into fixed income, or bonds provides relative safety from stock market fluctuations, and can provide cash flow in the form of interest. While this will help deal with threats posed by sequence risk, bonds also have a much lower rate of return.
Also on a similar line as fixed income, you can also hold cash reserves, which again is a safe asset allocation approach, albeit with an even lower risk and returns. Ensuring you don’t have to liquidate your more volatile investments, like stocks, during an economic downturn will help you weather the storm. Historically in the longer term, stocks have always increased in value. As a result, if you don’t need to sell during market low points, you can ride out the financial storms.
There are other options that provide some protection against sequence risk. Owning rental real estate properties can help generate extra cash flows. This again is a more diverse investment portfolio, and that diversification provides options.
But what if you are close to retirement, and don’t already have the appropriate asset allocation or real estate? The good news is, it’s not too late to start making your portfolio more conservative, or look at alternate investment options. Another key consideration is phasing into retirement more slowly. This could involve working part time, scaling back hours while still generating some income, which lowers the amount you need to withdraw from your retirement accounts in the short term.
Sequence risk can throw a wrench in our best laid investment plans. And with concerns over an impending recession, it’s never a better time to explore your options in case the global economy does slow down. There are many options that you can look into; from changing asset allocation to more conservative (less volatile) investments, to exploring real estate investment properties, or even working longer to weather an economic storm. Tough times will pass, and with the right tools at your disposal, those tough times don’t need to derail your financial future.