Sequence Risk may be a Retiree's Biggest Risk Overall.
"Sequence Risk" or "Sequence of Return Risk" applies to equity accounts burdened by fixed distributions. If Negative or even flat returns occur in the early years of withdrawals, long-term sustainability of the distributions will be permanently impaired. In short, lose money early and you will run out of money years before you planned. This is called Sequence of Return Risk and it only applies to accounts in distribution like retirement accounts. Google the term for broader explanations. I like the explanation given on The Balance web site.
Most financial plans project growth rates and future distributions in a few ways such as monte carlo simulations or straight line growth assumptions, (subjects of future posts). Advisers typically concentrate portfolios in well diversified portfolio of growth stocks and funds paying on average 1%/yr in dividends, inadequate to cover projected fixed withdrawals pegged at 4%-6% of Investment thereby requiring monthly liquidation of shares regardless of market direction. The remaining shares must, therefore, appreciate sufficiently to maintain portfolio balances and they may do so. But what if they don't appreciate or actually decline? This is why late-term investors cannot ignore Sequence Risk.
If at any point a retirement portfolio with fixed monthly distributions declines below investment by 10% , either through withdrawals or market activity, all forecasts go off track and serious revision are required. Allow your portfolio to Decline 15%, (ie. 5% withdrawals over three years in a flat market,) and recovery is nearly impossible as share depletion accelerates making distributions unsustainable well before the end of retirement. The consequence is that you'll run out of money long before you plan's projections. If you expect to leave an estate think again or die soon. And yes, markets will recover, but portfolios in distribution do not.
Planning for retirement is not simply a set of calculations you can set and forget, variables you plug in and expect the best. Good plans provide only a starting point and must be adjusted depending on real market conditions and performance. There are several things that can be done to reduce the impact of early market declines or flat markets on retirement portfolios and still participate in growth, but it takes discipline to focus on retirement income.
Following the original plan once serious declines have occurred is rarely the best alternative since time is not on your side and all the variables have changed. You'll be older, you'll have less money to start with, volatility may be higher or lower, your safe withdrawal rate is no longer safe. I emphasize that early portfolio declines are a call to action to avoid long-term disaster. Stop withdrawals or reduce them substantially, and do not liquidate equities to fund distributions.
Given that the most recent downturns took 2-4 years for full recovery, you'll need adequate reserves and stable assets to bridge the gap and preserve principal. If you're going cannibalize your assets, at least consume them in proper order.
Your best strategy to limit the impact of early declines is to structure a portfolio with cash, low volatility fixed income, and equities in proper proportion, and a distribution scheme that liquidates the cash and fixed income assets first, before liquidating any growth stocks, which will rebound over time.
I have written more extensively on this topic in an article, “LATE-TERM” INVESTORS, MONTE CARLO SIMULATION AND “SEQUENCE-OF-RETURN RISK”,
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