In the financial planning world, we call the 5 years before retirement and 5 years after retirement the Fragile Decade. It’s during this time that the market’s performance can have an outsize impact on whether your investments will last as long as you do throughout your retirement years. That’s because of something called Negative Sequence of Returns Risk, or Negative Sequencing for short, which is a mathematical phenomenon that becomes very real once you retire and start withdrawing a portion of your investments to supplement your income.
Why Negative Sequencing Can Put Your Retirement at Risk
In a nutshell, we know that market returns are quoted as an average. For example, “My IRA returned an average of 7%/year over the last three years.” But we also know that the average was earned as the market roller-coaster was in motion – some years returning more than 7%, some years less than 7%, but averaging out to 7% over that three-year period.
When you are building wealth as a pre-retiree, we really don’t care about that “sequence of returns” – some years up and some years down. The math shows that you end up with the same amount of money, no matter the sequence. But when you start withdrawing money, it does affect you. If you are withdrawing money in a down-market cycle or a “negative sequence” very early in your retirement years, then the account is shrinking by BOTH the negative market return AND your needed withdrawals. And when that happens, your account balance won’t last as long in your retirement years, as the average rate of return would misleadingly predict.
Two people can retire with identical strategies - $1 million invested in a 60/40 portfolio and withdrawing $50,000/year – except that the one retiring into a negative market cycle runs out of money in less than 20 years while the one retiring into a positive market cycle ends retirement with more money than he started with, and yet mathematically they have the same average return! Retirees need a different approach to their investing strategy, and it begins in the five years leading up to retirement.
Put Your Investments into Buckets
There is good news in all of this - Investment Bucket segmenting is an effective way to mitigate the unknown Sequence of Returns Risk that you’ll face. Here’s how you do it:
A NOW bucket has your bank accounts in it: safe, rainy-day money that everyone needs. No risk, but no reward either. That’s OK – gotta have it.
A SOON bucket has accounts that you’ll access for income in Phase 1 of retirement, roughly eight to 10 years. This may be a brokerage account and/or an IRA from which you’ll draw your RMD’s. These accounts are invested more conservatively to make their stock market ride a kiddie roller-coaster, with gentle ups and downs. This creates the income bridge to your LATER bucket.
A LATER bucket holds the rest of your accounts. These accounts are reserved for Phase 2 of retirement, roughly 10-plus years out. They can have a stronger growth orientation, and their stock market ride can be an adult-sized roller-coaster, knowing they have the magic word “time” to stay invested in the markets. Using the Rule of 72, LATER bucket accounts that earn an average of 7%/year will double every 10 years. So as these accounts grow, a portion of them will be poured back into the SOON bucket to refill those conservative accounts as income withdrawals slowly deplete them.
This Investment Bucket strategy is repeatable over and over again, throughout your long-lived retirement years, and is designed to reward you with growth in the LATER bucket while giving you confidence and security in the SOON bucket. It’s an effective strategy for mitigating the unknown sequence risk while you relax and enjoy life.