Personal Finance
Sequence of returns risk can hurt retiree portfolios. How to plan
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Stock market dips can create a big portfolio risk during your earlier retirement years — and many investors don’t prepare, financial experts say.
The issue, known as “sequence of returns risk,” refers to how the timing of withdrawals paired with stock market losses can impact how long your retirement saving lasts.
Your first five years of retirement are the “danger zone” for tapping accounts during a downturn, according to Amy Arnott, a portfolio strategist with Morningstar Research Services.
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If you take assets from accounts when the value is falling, “there’s less money left in the portfolio to benefit from an eventual rebound in the market,” she said.
Moreover, sequence risk can increase your chances of outliving retirement savings, Arnott said.
For example, let’s say your portfolio dropped by at least 15% during your first year of retirement and you also withdrew 3.3% of the balance.
That combination would increase your odds of depleting the portfolio within 30 years by six times compared to someone with a first-year positive return, according to a 2022 report from Morningstar. (This research assumed future yearly withdrawals were fixed at the same share of the portfolio.)
Negative returns are more harmful early in retirement than later, according to a 2024 report from Fidelity Investments. That’s because retirees miss more years of potential compound growth.
“It’s very difficult to overcome those losses in early years,” said David Peterson, head of advanced wealth solutions at Fidelity.
By comparison, early years of positive returns in retirement have “the advantage of the markets working in your favor,” he said.
Keep a ‘balanced asset allocation’
As you approach retirement, a “balanced asset allocation” is one of the best things investors can do to reduce sequence risk during early retirement years, Arnott said.
For example, there’s a lower sequence risk if your portfolio is 60% stocks and 40% bonds compared to heavier stock allocations, she said.
With the “proper asset allocation,” negative returns might not be as extreme for your portfolio as the stock market losses, Peterson said. Of course, the right mix ultimately depends on your risk tolerance and goals.
Adopt the ‘bucket approach’
You can also shield your portfolio from stock market losses with a retirement strategy known as the “bucket approach,” Arnott said.
Typically, you’ll keep one to two years of living expenses in cash, which would be accessible during market dips, she said.
The next five years of spending could be in short- to intermediate-term bonds or bond funds. Beyond that, the third bucket focuses on growth with stocks, Arnott said.
“It does take some maintenance from year to year,” but it could provide “peace of mind” while reducing sequence of returns risk, she said.
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You could face a 25% penalty
Generally, you calculate RMDs for each account by dividing the prior Dec. 31 balance by a “life expectancy factor,” according to the IRS. Some companies calculate RMDs for you, but you’re ultimately responsible for withdrawing the correct amount.
There’s a 25% penalty for skipping the RMD or not withdrawing enough, said certified financial planner Scott Bishop, partner and managing director of Presidio Wealth Partners, based in Houston.
But the IRS could reduce the fee to 10% if you correct the mistake, withdraw the proper amount within two years and file Form 5329.
“If you miss [the RMD], own up to it,” Bishop said. “Make sure you’re timely with it.”
In some cases, the IRS could waive the penalty entirely if you show the shortfall happened due to “reasonable error” and you’re taking “reasonable steps” to fix it, according to the agency.
Why you should take your first RMD sooner
While retirees have until April 1 the year after turning 73 for their first RMD, many advisors suggest withdrawing the funds by Dec. 31 of the previous year.
“I almost always say take it the first year,” said George Gagliardi, a CFP and founder of Coromandel Wealth Management in Lexington, Massachusetts.
If you wait until April 1 for your first RMD, you still have to take the second one by Dec. 31 of the same year. Pre-tax withdrawals incur regular income taxes, so you’re “doubling up” for that year, Gagliardi said.
Boosting your adjusted gross income can trigger various tax consequences, including higher Medicare Part B and D premiums.
However, there are some scenarios where it makes sense to delay your first RMD until April 1, Gagliardi said.
For example, the year you turn age 73 could be higher-income due to capital gains or another event that wouldn’t repeat, he said.
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