When planning for retirement, many people focus on how much they’ve saved—but an equally important factor is how and when those savings are used. One often overlooked risk is the sequence of returns: the order in which investment gains and losses occur once you begin withdrawing from your portfolio.
Even if your average return over time looks solid, a poorly timed market downturn early in retirement could dramatically reduce how long your savings last. This is especially true for retirees who rely on regular withdrawals to fund their lifestyle.
Understanding the relationship between increasing market volatility and retirement withdrawals is essential for long-term planning. In this article, we’ll unpack how sequence of returns risk in retirement works, why it matters more than many realize, and strategies that may help reduce its impact so you can move closer to your long-term goals.
What is Sequence of Returns Risk?
Sequence of returns risk refers to the impact that the timing of market gains and losses can have on a retirement portfolio once withdrawals begin. While long-term average returns are often used in retirement projections, the order in which those returns occur can make a meaningful difference in real life.
Market volatility during the early years of retirement can be especially challenging. When retirees are taking withdrawals at the same time their portfolio experiences losses, they may be forced to sell investments at lower values. That can permanently reduce the size of the portfolio and limit its ability to recover when markets rebound.
Consider two retirees with identical portfolios that earn the same average return over a 30-year period. On paper, their outcomes might appear equal. However, if one retiree experiences significant losses in the first few years of retirement while taking withdrawals—and the other experiences early gains—their long-term results can diverge dramatically. The retiree who encounters early losses may have fewer assets remaining to participate in future growth, increasing the likelihood of running short later in life.
For individuals who depend heavily on their investment accounts to generate income, understanding sequence of returns risk is essential. The timing of market swings can influence not just portfolio performance, but the sustainability of retirement income over decades.
How Sequence of Returns Risk in Retirement Can Affect Income
Consider the following scenarios:
- Potential for Positive Market Performance Early in Retirement: If the market performs well in the early years of retirement, investment balances may have more time to grow before withdrawals significantly reduce the overall portfolio. This strategy could potentially contribute to the longevity of funds during retirement.
- Negative Market Performance Early in Retirement: If the market declines in the early years of retirement, withdrawals from a shrinking portfolio can compound losses, reducing the amount of assets available to recover during market rebounds. This can lead to a higher chance of running out of funds later in retirement.
Because no one can predict market performance with certainty, retirees must consider strategies that help manage this risk.
Strategies to Manage Sequence of Returns Risk
While sequence of returns risk cannot be eliminated, there are ways to structure a financial plan that may reduce its potential impact. Below are several approaches to consider:
- Diversifying Income Sources
Relying solely on an investment portfolio for income may increase exposure to sequence risk. Diversifying income sources can provide flexibility and reduce reliance on market-dependent withdrawals. Options include:
- Social Security benefits
- Pensions (if available)
- Annuities that provide structured payouts
- Cash reserves or short-term bonds for near-term expenses
By drawing from multiple income sources, individuals may reduce the need to sell investments at inopportune times.
- Implementing a Withdrawal Strategy
Choosing an appropriate withdrawal method can help manage sequence of returns risk. Common approaches you may have heard of include:
- The 4% Rule: This method involves withdrawing 4% of the initial portfolio balance annually, adjusting for inflation. While widely used in the past, it’s important to note that it is not necessarily the standard approach anymore. If you are considering this strategy, know that it may require modifications based on market conditions and individual needs.
- Dynamic Withdrawal Strategies: Adjusting withdrawals based on market performance can be a strategy to manage risk during downturns. This may involve reducing spending in poor market years or using a percentage-based withdrawal strategy.
- Bucket Strategies: This approach involves organizing assets into different “buckets” based on their purpose and how they contribute to a retirement income strategy. By allocating funds across various types of accounts and investments, individuals can create a structured withdrawal plan that helps manage risk and tax efficiency. Some buckets may focus on readily accessible funds, while others are designed for future income needs or long-term growth. This strategy allows retirees to draw from different sources based on market conditions, tax considerations, and evolving financial goals.
A well-structured withdrawal plan helps individuals navigate market fluctuations while balancing income needs.
- Annuities as a Potential Option for Stability
Annuities may provide a source of structured income that is not directly tied to market performance. Options such as fixed annuities or fixed index annuities can provide predictable payouts, helping to reduce reliance on investment withdrawals during market downturns.
- Reducing Portfolio Risk in Early Retirement
Adjusting asset allocation in the early years of retirement can help manage volatility. A more conservative allocation with a mix of equities and fixed-income investments may reduce exposure to market downturns while still allowing for long-term growth.
Some retirees gradually shift assets toward lower-risk investments as they begin withdrawing funds, while others maintain a balanced allocation throughout retirement. Finding the right approach depends on an individual’s goals, risk tolerance, and overall financial strategy.
The Importance of a Thoughtful Retirement Plan
Because market conditions are unpredictable, planning ahead for sequence of returns risk can help individuals manage their financial resources effectively. By incorporating diversified income sources, structured withdrawal strategies, and appropriate asset allocation, retirees can develop a plan that adapts to different economic conditions.
Consulting with a financial professional can provide insight into how sequence of returns risk applies to an individual’s unique situation and what steps may be taken to navigate market uncertainty while maintaining financial stability.
Are You Planning to Avoid Sequence of Returns Risk in Retirement?
Sequence of returns risk is an important consideration in retirement planning, as market fluctuations in the early years of retirement can significantly impact long-term financial outcomes. By understanding how this risk works and implementing strategies such as income diversification, structured withdrawals, and asset allocation adjustments, retirees can develop an approach that helps them manage market-related uncertainties.
Since no one can predict market performance, having a plan in place to address sequence risk is an important part of building a sustainable retirement strategy. By taking proactive steps today, individuals can better prepare for the financial realities of retirement.
If you’re interested in learning more about sequence of returns risk and how it may impact your retirement income plan, please reach out to schedule a complimentary strategy session today. We look forward to hearing from you!