There’s a lot to consider when preparing for retirement, including how much to save, how your investments are allocated, and how you’ll turn those savings into income. But there’s another risk that can become particularly important as you transition from saving to spending: sequence-of-returns risk.
Sequence risk isn’t simply about whether the market goes up or down. It’s about when those returns occur and how they interact with withdrawals from your portfolio.
Understanding this risk can help you see why retirement income planning involves more than choosing investments or targeting a particular rate of return.
What Is Sequence-of-Returns Risk?
Sequence-of-returns risk refers to the possibility that poor investment returns early in retirement can have an outsized effect on how long a portfolio lasts when you’re also withdrawing money from it.
Imagine two retirees who begin with identical portfolios, withdraw the same amount, and experience the same set of investment returns over retirement.
The difference? They experience those returns in a different order.
One experiences strong returns early in retirement and market declines later. The other experiences those market declines during the first few years of retirement.
Even though their average returns may ultimately be similar, their ending portfolio values can be dramatically different because withdrawals occurred along the way. Current retirement research continues to demonstrate this effect.
The order of investment returns can matter significantly once you’re withdrawing money from a portfolio.
Why Sequence Risk Becomes More Important in Retirement
During your working years, you’re generally adding money to your retirement accounts rather than relying on them for income.
Once retirement begins, that relationship changes.
Suppose the market declines and you need $50,000 from your portfolio for living expenses. Selling investments after they’ve declined means you’re withdrawing from a smaller portfolio and potentially selling more shares to generate the income you need.
Once those shares have been sold, they’re no longer invested when markets eventually recover.
A significant market decline early in retirement combined with ongoing withdrawals can therefore make it harder for a portfolio to recover, potentially affecting how long those assets last.
Sequence Risk Isn’t the Same as Market Risk
It’s helpful to distinguish sequence risk from ordinary market risk.
Market risk is the possibility that investments will decline in value.
Sequence-of-returns risk is the additional risk created by the timing of market gains and losses when you’re also withdrawing money.
An investor who isn’t taking withdrawals may be able to remain invested through a downturn and participate fully in a subsequent recovery. A retiree relying on portfolio withdrawals may have less flexibility.
That’s why the transition from accumulating assets to drawing income can require a different type of planning.
How Can Sequence Risk Be Managed?
Sequence risk can’t be eliminated, and no one knows when the next market downturn will occur. However, a retirement income plan can account for the possibility.
Several approaches may be considered depending on an individual’s circumstances.
Maintain an Appropriate Asset Allocation
Retirement doesn’t necessarily mean eliminating stocks from a portfolio.
Stocks may continue to provide long-term growth potential, while bonds, cash, and other investments may provide different sources of stability and income.
The appropriate mix depends on factors such as retirement goals, time horizon, income needs, and tolerance for market fluctuations.
Diversification doesn’t guarantee against losses, but spreading investments across different asset classes can help manage portfolio risk.
Build Flexibility Into Retirement Spending
Not every retirement expense has the same level of flexibility.
Housing, healthcare, food, and other essential expenses generally need to be paid regardless of market conditions. Travel, entertainment, gifts, and some discretionary purchases may offer more flexibility.
Some retirees use a dynamic withdrawal strategy, adjusting discretionary withdrawals within predetermined ranges based on portfolio performance. For example, spending may be reduced modestly after significant market declines rather than automatically increasing withdrawals every year.
Research suggests that this type of flexibility can help manage sequence risk, although the appropriate strategy varies by individual.
Consider Where Retirement Income Will Come From
Retirement income may come from several sources, including:
- Social Security.
- Pensions.
- Cash reserves.
- Taxable investment accounts.
- Traditional retirement accounts.
- Roth accounts.
- Annuities, when applicable.
Understanding which expenses are covered by predictable income and which require portfolio withdrawals can help clarify how exposed a retirement plan may be to market fluctuations.
The tax consequences of withdrawals can also differ depending on the account, so withdrawal decisions may involve both investment and tax considerations.
Maintain Appropriate Cash Reserves
Some retirees maintain cash or other relatively stable assets for near-term spending needs.
Having readily available funds may provide greater flexibility during periods of market volatility because some expenses can potentially be funded without immediately selling investments that have declined in value.
However, holding too much in cash also has tradeoffs, including inflation risk and reduced long-term growth potential. The appropriate amount depends on the individual’s circumstances and retirement income plan.
Review Your Withdrawal Strategy
How much you withdraw can be just as important as where the money comes from.
A withdrawal rate that works under one set of assumptions may not work under another. Longevity, inflation, market returns, spending needs, taxes, and portfolio composition can all affect how long retirement savings may last.
This is one reason retirement withdrawal strategies may need to be revisited rather than treated as a decision made once at retirement.
Don’t Overlook Inflation and Longevity
Sequence risk doesn’t exist in isolation.
Retirees may also face inflation, unexpected healthcare expenses, changing tax circumstances, and the possibility of living longer than anticipated.
For example, holding more cash may reduce the need to sell investments during a downturn, but cash may lose purchasing power over time. Holding more stocks may provide greater long-term growth potential, but it can also expose a portfolio to greater short-term volatility.
Retirement planning often involves balancing multiple risks rather than trying to eliminate any single one.
The Early Years of Retirement Deserve Attention
Sequence risk is often associated with the first several years of retirement because significant losses combined with withdrawals during this period can affect the portfolio available to support later years.
That doesn’t mean retirees should try to predict the next bear market or choose their retirement date based on market forecasts.
Instead, it highlights the value of entering retirement with a plan for how income needs could be managed across different market environments.
The Bottom Line
Sequence-of-returns risk illustrates an important distinction between saving for retirement and living in retirement: once withdrawals begin, the timing of market returns can have a significant impact on how long a retirement portfolio lasts.
There is no single strategy that eliminates this risk. Asset allocation, diversification, spending flexibility, cash-flow planning, withdrawal decisions, taxes, and other income sources can all play a role in how a retirement plan responds to changing markets.
At Navalign Wealth Partners, we help clients evaluate retirement income decisions within the context of their broader financial plan, including how investments, taxes, spending needs, and other income sources work together throughout retirement.