Understanding Sequence of Returns Risk and How to Mitigate It with Diversification

When planning for retirement, there are many financial risks to consider. Among them, one often overlooked but critical risk is Sequence of Returns Risk (SoR risk). This risk can have a devastating impact on your retirement savings and overall quality of life if not properly addressed. Fortunately, there are ways to mitigate it through smart diversification, including strategies like fixed indexed annuities and cash-value life insurance.

This post will break down what Sequence of Returns risk is, how it affects retirees, and practical steps you can take to safeguard your financial future. By the end, you’ll have the tools to build a retirement strategy designed to weather even the most volatile markets.

What is Sequence of Returns Risk?

Sequence of Returns Risk refers to the danger that the timing of market losses can have a disproportionately large effect on your retirement savings. While most people understand that markets go up and down, they may not realize the order of these ups and downs can be just as important as the overall average return.

Here’s why: When you’re withdrawing money from your portfolio, early losses reduce the base from which your portfolio can recover. Even if the market eventually rebounds, the combination of withdrawals and early losses makes it difficult for your portfolio to regain its original value.

Example: Retiring at the Start of a Bear Market

Imagine you’ve just retired with $1 million saved, and you’re planning to withdraw 4% annually—$40,000 for your living expenses. In the first year of retirement, the market crashes, and your portfolio drops by 30%. Your $1 million is now worth $700,000. You still need to withdraw $40,000, further reducing your balance to $660,000.

Even if the market rebounds in subsequent years, your portfolio is working with a much smaller base. The impact of those early losses, compounded by withdrawals, can drastically shorten the lifespan of your savings. This is the essence of Sequence of Returns risk. You essentially have to withdraw more of your account while it’s down, and there’s less remaining to recover, creating a ripple effect. 

How Sequence of Returns Risk Can Impact Your Standard of Living

For retirees, the implications of Sequence of Returns risk can be severe. Without proper planning, this risk can force difficult decisions that affect your lifestyle and financial stability.

1. Reduced Withdrawals: To prevent depleting your savings too quickly, you might need to cut back on withdrawals. This can mean scaling back your lifestyle—delaying travel plans, downsizing your home, or sacrificing hobbies.
2. Running Out of Money: If adjustments aren’t made, retirees risk depleting their savings entirely. A prolonged bear market combined with steady withdrawals can lead to financial ruin.
3. Emotional Stress: Beyond the numbers, SoR risk can create anxiety and uncertainty. Watching your savings dwindle early in retirement can lead to sleepless nights and a constant fear of financial insecurity.

Clearly, this is not a risk to ignore. Understanding it is the first step toward managing it effectively.

The Role of Diversification in Mitigating Sequence of Returns Risk

Diversification is one of the most powerful tools for mitigating financial risk. Most people think “I need to diversify the investments inside my portfolio.” While this may be true; we take diversification one step further. One should diversify their asset classes. In simple terms, it involves spreading your investments across different asset classes to reduce your reliance on any single source of income. For retirees, this is especially important.

How Diversification Helps

• Reduces Exposure to Market Volatility: By including assets that aren’t directly tied to market performance, diversification provides a cushion during downturns.
• Protects Against Timing Risk: A diversified portfolio ensures you have access to funds that aren’t affected by Sequence of Returns risk.
• Supports Long-Term Stability: Combining growth-oriented assets with income-generating and stable investments helps balance your portfolio over time.

While traditional diversification includes stocks, bonds, and perhaps real estate, this may not be enough for retirees. Incorporating non-market-correlated assets like fixed indexed annuities or cash-value life insurance can provide the additional safety net you need.

Fixed Indexed Annuities and Life Insurance: Alternatives to Mitigate SoR Risk

Fixed Indexed Annuities

Fixed indexed annuities are financial products that offer the potential for growth based on the performance of a market index, such as the S&P 500, without exposing your principal to market risk. These annuities are designed to provide a guaranteed income stream, which can be a game-changer for retirees.

Benefits of Fixed Indexed Annuities:

• Principal Protection: Your initial investment is safeguarded, so you do not lose money, even in a bear market. 
• Guaranteed Income: These annuities provide a predictable income stream, helping cover essential expenses. This income stream can be “locked-in” for life.
• Market Participation: While your principal is protected, you can still earn returns linked to market performance, up to a cap.

For retirees worried about Sequence of Returns risk, fixed indexed annuities offer peace of mind. By allocating a portion of your portfolio to this product, you create a reliable income source that isn’t affected by market downturns.

Life Insurance as a Safe Investment Alternative

Most people think of life insurance solely as a death benefit for their heirs. However, permanent life insurance policies, such as whole or indexed universal life insurance, come with an amazing feature: cash value growth. This cash value grows tax-deferred and can be accessed on a tax free basis. This creates an extremely powerful tax free alternative.

Benefits of Life Insurance:

• Tax-Deferred Growth: The cash value in your policy grows over time, untouched by taxes.
• Loan Access: During bear markets, you can access the cash value in your policy instead of selling investments at a loss.
• Zero Market Risk: The cash value is protected from market losses, but offers returns correlating with a market index.

By including life insurance in your financial strategy, you create a buffer for times of market instability. This allows you to protect your market-dependent portfolio, maintain your standard of living, and decrease your future taxes.

Case Studies: The Impact of Sequences of Return Risk With and Without Diversification

Case Study 1: Retiree with a Market-Dependent Portfolio

John retires at 65 with $1 million in a 401(k). He plans to withdraw 4% annually, or $40,000, to cover his living expenses. Unfortunately, the market enters a bear phase in his first year of retirement, and his portfolio loses 30%.

• Portfolio Value After Year 1: $700,000 (after a 30% loss).
• Withdrawals: $40,000 for expenses.
• Remaining Balance: $660,000.

Over time, continued withdrawals and market volatility erode John’s savings. By age 80, he runs out of money unless he significantly reduces his standard of living. The early losses create a hole too deep to recover from.

Case Study 2: Retiree with Diversified Assets

Jane retires with $1 million, split evenly between a 401(k) and a cash-value life insurance policy. In her first year of retirement, the market also drops by 30%. Instead of withdrawing from her 401(k), Jane takes a loan from her life insurance policy to cover her $40,000 living expenses.

• 401(k) Balance After Market Loss: $350,000.
• Life Insurance Loan: $40,000 (preserves 401(k)).

As the market recovers, Jane’s 401(k) regains its value. She resumes withdrawals once her portfolio stabilizes, ensuring she doesn’t lock in losses. By diversifying her assets, Jane maintains her quality of life and protects her financial future.

Why Diversification Should Include More Than Traditional Assets

Traditional portfolios of stocks and bonds may provide diversification during accumulation years, but retirees face unique challenges. Adding non-market-correlated assets, such as fixed indexed annuities or cash-value life insurance, creates an additional layer of security.

By including these tools in your financial plan, you gain:

• Predictable Income: Annuities provide steady cash flow.
• Accessible Reserves: Life insurance loans help you avoid selling investments during downturns.
• Peace of Mind: A diversified strategy ensures financial stability, even in turbulent markets.

Conclusion

Sequence of Returns risk is a real and significant threat to retirees. Early losses combined with withdrawals can quickly deplete savings and force difficult lifestyle changes. However, with proper planning and diversification, you can protect yourself against this risk.

Fixed indexed annuities and cash-value life insurance offer powerful solutions. By incorporating these tools into your retirement strategy, you create a financial safety net that allows you to weather market volatility and maintain your standard of living.

Now is the time to act. If you need help, book a free consultation to explore your options and build a resilient retirement plan. Your future self will thank you.