The dangers of downside market risk and sequence of return risk are two of the most critical threats modern retirees face when managing their retirement income. Both risks can have a profound impact on the long-term sustainability of retirement savings, potentially leading to premature depletion of assets or requiring a drastic reduction in lifestyle. Let’s delve into these two risks in more detail:
 

1. Downside Market Risk
 

Downside market risk refers to the potential for losses in the financial markets, particularly in the context of the investment portfolios that retirees rely on for income. When markets experience a downturn or bear market (where asset prices decline significantly), the value of the retiree’s investment portfolio can drop, which can have several adverse consequences:
 

• Reduced Portfolio Value: If the markets decline during retirement, the retiree’s portfolio value decreases, meaning there is less capital from which to draw income. For example, if you had a $1 million portfolio and the market drops by 20%, that portfolio is now worth $800,000. If you were planning to withdraw 4% of your portfolio each year, the reduction in value means you are withdrawing a larger percentage of a smaller pot, which accelerates the depletion of the portfolio.
   

• Challenging Recovery: The most dangerous downside market risk occurs when a retiree is forced to sell investments at a loss to meet income needs. If the market is down when they need to sell, they could lock in losses, reducing the chances of future recovery, especially if they experience multiple years of losses or poor returns.
   

• Loss of Purchasing Power: In addition to a nominal loss in value, a market downturn may also coincide with inflation, which erodes the purchasing power of your income. If you rely on a portfolio that is heavily exposed to equities or other volatile assets, the risk of real income loss increases in a bear market.
  
   

2. Sequence of Return Risk
 

Sequence of return risk is the risk that the order or timing of investment returns can significantly affect the sustainability of withdrawals from a portfolio, especially when withdrawals are made during periods of market decline. The sequence in which returns occur is just as important (if not more) than the overall return over the long run. Let’s illustrate how this works:
 

• Early Losses are Particularly Harmful: Sequence risk is most dangerous when the retiree faces negative returns early in retirement. If the market goes down just as a retiree begins drawing income, the retiree may have to sell more shares to meet the same income target. Selling investments in a down market locks in losses and reduces the number of assets available for recovery. The longer the downturn persists, the harder it becomes to recover, especially with withdrawals continuing.
   

  • Example: Suppose you retire with $1 million and plan to withdraw $40,000 annually. If your first few years of retirement are marked by a market downturn (e.g., a 30% loss in the first two years), your portfolio may fall to $600,000. To meet your $40,000 withdrawal, you are now selling more of your portfolio at a loss. If the market recovers in the later years, the portfolio will not have as much capital to participate in that recovery because you’ve already sold off a portion of it in the early years.
     

• The Timing of Market Returns Matters: Even if the average long-term return of the market over 30 years is 7% per year, if the early years involve significant losses, your portfolio could be much worse off than if those losses were postponed to later years. This is because the compounding effect works against you when you are withdrawing funds from a shrinking portfolio.
   

  • Example of Different Sequences: Consider two retirees, both of whom have a $1 million portfolio and withdraw $40,000 annually. Retiree A experiences a 5% return for the first five years and then a 10% return for the next five years. Retiree B experiences a 10% return for the first five years and a -5% return for the next five years. Despite both having the same average return over 10 years, Retiree A will likely end up with a much higher portfolio balance after 10 years than Retiree B due to the order in which returns occurred. Retiree A’s portfolio grew during a period of withdrawals, while Retiree B’s portfolio shrank when withdrawals were being made.
    
     

Why These Risks Are Particularly Dangerous for Modern Retirees
 

1. Longer Life Expectancies: People are living longer, which increases the duration of retirement. The longer the retirement horizon, the greater the chance that a retiree will experience market downturns during their retirement, and the more time they need for their portfolio to recover. Long retirements mean the effects of downside market risk and sequence of return risk can compound, requiring more careful planning.
    

2. Withdrawal Strategies: Many modern retirees rely on systematic withdrawals—taking a fixed percentage or dollar amount from their portfolio each year to cover living expenses. While this strategy is popular, it is highly susceptible to sequence of return risk, especially during a bear market or period of flat returns. For example, the traditional 4% withdrawal rule assumes that the retiree’s portfolio will grow at a consistent rate. But if the market takes a significant downturn early in retirement, that 4% withdrawal becomes a much higher percentage of a diminished portfolio, which can deplete funds prematurely.
    

3. Reliance on Equity-Heavy Portfolios: Modern retirees often hold a significant portion of their retirement portfolio in equities (stocks) because of their potential for higher long-term returns. However, equities are also the most volatile assets. If a retiree is heavily invested in stocks and faces a downturn in the first years of retirement, it can significantly harm the portfolio’s ability to recover.
    

4. Low-Interest Rates on Safe Investments: With interest rates at historically low levels, retirees are earning little on more "safe" investments like bonds or certificates of deposit (CDs). As a result, many retirees are forced to take on more risk by investing in equities or riskier assets. However, this exposes them to the potential downside market risk and sequence of return risk during their retirement years, particularly if they don’t have sufficient income streams from safer investments like annuities or Social Security.
   
    

Mitigating Downside Market Risk and Sequence of Return Risk
 

To protect against these risks, retirees and pre-retirees can adopt several strategies:
 

1. Diversification: Spreading investments across asset classes (stocks, bonds, real estate, alternative assets, etc.) can reduce the impact of any one asset class performing poorly. This can help reduce downside market risk, especially in periods of market volatility.
    

2. Staggered Withdrawal Strategies: Retirees can use a bucket strategy, where they create separate "buckets" of assets for different time periods. For example, one bucket might hold safe, liquid assets for the first 5-10 years of retirement (like bonds or cash), while another holds riskier assets (like stocks) for longer-term growth. This can reduce the need to sell risky assets during a market downturn.
    

3. Annuities: Using lifetime income annuities, such as longevity annuities or immediate annuities, can help mitigate both downside market risk and sequence of return risk. These annuities provide guaranteed income for life, no matter what happens in the market, ensuring that the retiree has a stable income stream even during periods of market volatility.
    

4. Flexible Spending: Adjusting withdrawal rates based on market conditions can help retirees manage sequence of return risk. If the market is down, they might reduce withdrawals temporarily and increase them when the market is up.
    

5. Delaying Social Security: Delaying Social Security benefits can provide higher payouts and increase retirement security. It also reduces reliance on withdrawals from the portfolio, especially during periods of market volatility.
   
    

Conclusion
 

The dangers of downside market risk and sequence of return risk represent significant threats to modern retirees, who rely on their portfolios to generate income throughout retirement. Market downturns, especially early in retirement, can have devastating effects on a portfolio’s sustainability, as retirees may be forced to sell investments at a loss. Understanding these risks—and adopting strategies such as diversification, income annuities, and withdrawal planning—can help mitigate the potential harm they cause and increase the likelihood of a secure and sustainable retirement.