Why Sequence of Returns Risk Matters Now
That year or two when you are closing in on your retirement date, followed by a year or two after you retire, are the worst times for a sustained market decline. Market analysts call this scenario the sequence of returns (SOR) risk ‚Äì because once your principal has been significantly reduced, there is not enough time in the market left for you to recover those losses.¬†
Two things will likely happen. First, the amount of retirement income you can withdraw each year is irrevocably reduced. For example, if you were planning to withdraw 4 percent a year from a $350,000 portfolio, you would have received a supplementary income of $14,000 a year. But if your principal drops to $280,000 a year, your 4 percent draw will generate only $11,200 a year. If you need that additional money, you will have to increase your draw to about 5 percent of the principal each year.¬†
This leads us to the second consequence of a market decline: your principal will diminish faster. The longer you live, the greater your chances of running out of money.¬†
How Big Is This Problem?
Because the coronavirus pandemic has sent stock markets reeling over the past few months, SOR risk has become a widespread concern. According to research by Spectrem Group, at the end of 2019, there were 11 million millionaires in the United States. By the end of March this year, at least half a million of those people were no longer millionaires.¬†¬†
While losses among millionaires may be disconcerting, the situation is far more dire for middle class investors, who might not have several hundred thousand dollars to spare in their retirement portfolio.¬†
Strategies for Offsetting SOR Risk
If the last recession is any indicator, the economic recovery going forward could take several years. That is not good news for people who were looking forward to retiring soon. This group may want to seriously consider the merits of delaying retirement and continuing to work longer, such as:¬†
- Allowing their portfolio time to recover
- Continuing to contribute to tax-advantaged retirement accounts
- Enabling their Social Security benefits to accrue higher¬†
Another strategy to help protect your portfolio against future SOR risk is to position a larger allocation to fixed-income assets and/or an annuity. While this might limit your potential for income growth in the future, these assets are backed by more reliable payors and less subject to the vagaries of the stock market. By diversifying your current assets, you can build multiple streams of reliable income to protect you from the future threat of market losses, a global pandemic, or changes in Social Security benefits.¬†
It is worth considering that once we emerge from this current crisis, legislators will have to find a way to deal with the federal deficit and growing debt. The Social Security program was already projected to cut benefits by 2035 without any new funding solutions. Now, that threat is even further exacerbated by the enormous jump in unemployment numbers. This situation leaves even fewer people paying into the Social Security and Medicare programs.¬†
For these reasons, it is very important to address today‚Äôs challenges presented by the sequence of returns risk. Explore ways to develop multiple income streams to protect your current assets and ensure they last throughout your lifetime.