Understanding Sequence of Returns Risk & How It Can Impact Your Retirement

When there's market volatility, it's natural to get nervous about your retirement savings and to consider withdrawing some of the money earlier than you intended. However, making financial decisions out of fear is typically not a good idea. If you're close to retirement, it's important to understand how different factors can impact your retirement savings.

Sequence of returns risk is one of them. Here's what you need to know about this risk and how it can affect your retirement planning.

What Is Sequence of Returns Risk?

This type of risk involves the order in which your investments generate a return and the timing of your planned withdrawals. If your investments produce a negative return early in your retirement and you need to cash in some of your stock or bonds for a withdrawal, this could significantly affect the amount of retirement savings you have.

Impact of Sequence of Returns Risk

For example, let's say the money you've invested in your 401(k) or IRA has grown to $1 million. You'd like to retire early at age 60, but then a recession hits during the year you plan to retire, the value of your stocks decreases, and your retirement savings dips to a total of $875,000. In this scenario, you could generally consider two approaches: You could still retire early and begin taking withdrawals, even though the market is down (which means your retirement savings may not last as long), or you could consider waiting several months or more until things get better and your retirement savings start to recover. The latter approach could help ensure your first withdrawals have a smaller impact on your total retirement savings.

Navigating Sequence of Returns Risk

Again, there's no certainty with the stock market — the value of stocks rise and fall every day. However, understanding your risk tolerance, how much you need to enjoy a comfortable retirement, and seeking advice from the right financial professionals can help you navigate sequence of returns risk and make an informed decision about how to best manage your retirement savings from year to year.

How to Manage Sequence of Returns Risk

If you're thinking about retiring in the next few years, here are some things to consider for managing sequence of returns risk:

Consider Rebalancing Your Portfolio

As people approach retirement, their investments generally get more conservative. If you're nearing retirement, you may want to consider the same approach, which generally will require selling some of the assets in your retirement account (either stocks or bonds) to achieve both the investment mix and the level of risk you're comfortable with. Consider talking to a financial professional about the best way to rebalance your portfolio.

Consider Using a Savings Account

Relying on a savings account is another approach to explore. A high-yield savings account backed by an FDIC-insured bank can be a good option to consider. Like regular savings accounts, these accounts allow you to withdraw money at your own discretion, but they earn a higher interest rate on what you save.

You could set aside a couple of years of retirement savings in this account, using money that you've earmarked or withdrawn from your retirement account. This way, you may not be forced to withdraw money from your retirement savings during a year when you have a negative return.

Understanding the Impact of Sequence of Returns Risk

Sequence of returns risk can have a significant impact on your retirement savings, especially if you need to access your retirement savings during a time when the market is down. However, understanding this risk can help you make the right decision for your situation.