Sequence of return risk: How it can hurt your retirement planning and ways to mitigate it

Suppose you are retiring after accumulating your desired equity corpus. You have also decided the rate at which you will withdraw funds for your daily needs in retirement. However, a sudden market downturn reduces your corpus as soon as you retire, but you can't stop withdrawing at the rate you had decided earlier. What happens in this situation?

Sudden market downturns can jeopardise even the best of retirement plans that rely on regular withdrawals from investment portfolios. Your corpus will deplete faster than you had calculated before retiring.

But what if the markets go through a downturn towards the end of your post-retirement life? In this case, the equity portion of your investment portfolio will get enough time to grow, increasing the chances of your corpus to last as per the plan or even longer based on the returns realised before the onset of the downturn.

Thus, the specific order of negative or positive market returns can dramatically shape financial outcomes in retirement. In retirement planning, this is known as the sequence risk or the sequence of returns risk. It is especially critical for those depending on regular withdrawals from their investment portfolios.

What is the sequence of returns risk?

Sequence of returns risk refers to the risk to an investment portfolio due to the timing of poor market returns during the decumulation phase in retirement. The basic premise of this risk is that severe portfolio losses at the start of one's retirement can significantly compromise the sustainability of the retirement savings for the desired period of time. Let's understand with three scenarios:

1. Normal situation as per plan: In this case, your retirement savings will last as planned. You will withdraw a fixed amount at a fixed rate while the remaining corpus will remain invested and earn returns.

2. Downturn at the start: In this case, the retirement savings may deplete faster than planned. A sudden market downturn can reduce the total value of the portfolio. This means the capital remaining for investment after withdrawal will also shrink. So even if the markets rebound later, you will have lower returns in absolute terms to sustain your savings as planned.

3. Downturn at the end: In this case, the retirement savings may last till the desired period. If the market downturn starts towards the end of your decumulation phase, your invested corpus will get more time to grow while enabling regular withdrawals to fund your needs.

How to mitigate sequence risks

While timing the market to eliminate the sequence of returns risk is not possible, one can adopt multiple strategies to mitigate the impact of a sudden market downturn early in retirement: