Understanding Sequence of Returns Risk in Retirement
Retirement planning involves more than estimating an average rate of return. For investors approaching or entering retirement, the timing of investment returns can matter just as much as the long-term average.
This is known as sequence of returns risk.
Sequence of returns risk refers to the risk that negative investment returns occur early in retirement while withdrawals are beginning. When market declines and portfolio withdrawals happen at the same time, the impact on long-term portfolio sustainability can be greater than many investors expect.
Key Takeaways
Sequence of returns risk is most important when withdrawals begin.
Early market losses can have a larger impact than losses that occur later.
Two investors can earn the same average return over time and still experience different retirement outcomes.
Diversification, liquidity, and flexible withdrawals may help manage risk, but none guarantees success or prevents loss. (finra.org)
What Is Sequence of Returns Risk?
Sequence of returns risk occurs when poor market returns happen early in retirement during the years a portfolio is being used to support spending.
During the accumulation phase, investors are often still contributing to their portfolios, which can help offset market declines over time. In retirement, that dynamic usually changes because withdrawals begin and contributions typically stop.
As a result, a significant decline early in retirement may reduce the portfolio base available to participate in a future recovery.
Why the Order of Returns Matters
Two retirees may experience the same average return over time, yet have very different outcomes if the order of those returns is different.
If one retiree experiences stronger returns early in retirement, the portfolio may have more opportunity to grow before withdrawals gradually reduce the balance. If another retiree experiences losses early in retirement, withdrawals during those weaker years may place greater strain on the portfolio.
In other words, the order of returns can influence how long retirement assets may last, even if long-term average returns are similar.
A Simple Example
Consider two retirees with similar portfolios, similar withdrawal needs, and the same average return over a long period.
Retiree A experiences stronger returns in the first several years of retirement and weaker returns later.
Retiree B experiences market losses in the first several years and stronger returns later.
Even if their long-term average return ends up being the same, Retiree B’s portfolio may be depleted more quickly because withdrawals occurred while the portfolio was already under pressure.
When Sequence Risk Is Most Relevant
Sequence of returns risk is often most relevant in the years just before and after retirement, when:
Portfolio withdrawals begin
Ongoing contributions stop
The portfolio takes on a larger role in supporting income needs
The early years of retirement are often viewed as especially sensitive because the portfolio may need to support spending for decades, and early losses can make recovery more difficult.
Approaches That May Help Manage Sequence Risk
No strategy can eliminate market risk or guarantee a successful retirement outcome, but several planning approaches may help manage sequence risk. The SEC’s marketing guidance emphasizes that potential benefits should be presented together with material risks and limitations, so those tradeoffs are important to acknowledge. (sec.gov)
Diversification
A diversified portfolio may help reduce reliance on the performance of any one asset class, sector, or security. Different investments may respond differently to changing market conditions, which can help moderate overall volatility over time.
However, diversification does not assure a profit or protect against loss. FINRA says this explicitly in its investor guidance. (finra.org)
Maintaining Short-Term Liquidity
Some investors maintain a portion of their portfolio in cash or other relatively liquid investments to help cover near-term spending needs. This may reduce the need to sell longer-term investments during periods of market stress.
At the same time, holding more assets in lower-volatility investments can involve tradeoffs, including lower expected returns, reduced long-term growth potential, and greater risk that inflation erodes purchasing power over time.
Flexible Withdrawals
In some cases, adjusting withdrawals during periods of market weakness may reduce pressure on a portfolio. This approach may not be practical for every retiree, but spending flexibility can be an important part of retirement planning.
For example, delaying a large discretionary expense or reducing withdrawals temporarily during a downturn may help preserve portfolio assets.
Long-Term Discipline
Maintaining a disciplined investment approach during volatile markets may help investors avoid decisions driven primarily by short-term market movements.
FINRA notes that selling investments during weak markets can lock in losses. At the same time, past market recoveries do not guarantee future results, so investment decisions should be tied to an investor’s broader plan, time horizon, and risk tolerance. (finra.org)
Other Factors That Matter
Sequence risk is important, but it is only one part of retirement planning. Long-term outcomes can also be affected by:
Withdrawal rate
Inflation
Taxes
Asset allocation
Longevity
Unexpected spending needs
Because of these variables, sequence risk is usually best evaluated as part of a broader retirement income strategy rather than in isolation.
The Bottom Line
Sequence of returns risk highlights an important aspect of retirement planning: when returns occur can matter, not just how much a portfolio earns on average.
For investors nearing or entering retirement, understanding this concept may help inform decisions about portfolio structure, liquidity, and withdrawal planning. While no strategy can remove uncertainty from investing, thoughtful planning may help investors prepare for the risks that can arise during the retirement transition.
If you would like to discuss how these concepts may apply to your own financial situation, BDB Wealth Advisors is available to have a conversation.
Disclosure: This material is provided for informational and educational purposes only and does not constitute individualized investment, tax, or legal advice, or a recommendation to buy or sell any security or adopt any specific investment strategy. Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results. Diversification, asset allocation, and withdrawal planning do not assure a profit or protect against loss. Any retirement income strategy should be evaluated in light of an investor’s objectives, risk tolerance, time horizon, liquidity needs, and overall financial circumstances. (sec.gov)