Introduction
Retirement planning involves more than saving enough money and choosing investments. The timing of investment gains and losses can also affect how long your savings last. This challenge is known as sequence-of-returns risk, and it is particularly important for people who have started withdrawing money from their retirement portfolios.
Two retirees can begin retirement with the same amount of savings and earn the same average investment return over time, yet experience very different financial outcomes. If one retiree experiences significant market losses early in retirement while continuing to withdraw money, their portfolio may be depleted more quickly.
Understanding sequence-of-returns risk can help retirees make informed decisions about withdrawals, diversification, cash reserves, and investment strategies. Although market fluctuations cannot be eliminated, thoughtful planning can help reduce their potential impact on retirement income.
What Is Sequence-of-Returns Risk?
Sequence-of-returns risk is the risk that the order of investment gains and losses will negatively affect a retirement portfolio, especially when withdrawals are being made.
During the accumulation phase, investors generally contribute money to their accounts and aim to grow their savings over time. Once retirement begins, the situation changes. Instead of adding money, retirees often withdraw funds to pay for living expenses.
When markets decline early in retirement, withdrawals can force investors to sell investments at reduced prices. Those assets are then unavailable to participate in a future market recovery.
For example, imagine two retirees who each begin retirement with $500,000. Both experience the same investment returns over a particular period, but the returns occur in a different order. The retiree who experiences negative returns early while withdrawing money may end up with less money than the retiree who experiences stronger returns first.
This difference occurs because withdrawals change the amount of capital remaining in the portfolio. The timing of gains and losses matters, not just the average return.
Why Does Sequence-of-Returns Risk Matter in Retirement?
Sequence-of-returns risk becomes more significant when investors depend on their portfolios to generate regular income.
1. Early Losses Can Have Lasting Effects
A large market decline during the first few years of retirement can damage a portfolio when withdrawals are already reducing its balance.
Suppose a retiree withdraws money during a market downturn. They may need to sell more shares to generate the same amount of cash. Even if the market eventually recovers, the portfolio may have fewer shares available to benefit from that recovery.
This can make it harder to restore the portfolio’s previous value.
2. Withdrawals Reduce Recovery Potential
Without withdrawals, an investor can often leave investments untouched during a downturn and wait for a potential recovery. Retirees, however, may need money for housing, groceries, utilities, healthcare, and other essential expenses.
These withdrawals can reduce the portfolio’s ability to recover, particularly when losses occur early in retirement.
3. Retirement May Last for Decades
A retirement portfolio may need to support 20, 25, or even 30 years of expenses. Early losses can therefore affect the portfolio for many years.
Retirees also face uncertainty about future investment returns, inflation, healthcare costs, and how long they will live. These factors make a flexible financial plan especially important.
For related retirement planning considerations, understanding longevity risk in retirement can help explain why savings may need to last longer than initially expected.
How Can Retirees Manage Sequence-of-Returns Risk?
1. Keep a Cash Reserve
Maintaining cash or other relatively liquid assets for near-term expenses may help retirees avoid selling stocks during a market decline. Some retirees keep several months or a few years of planned withdrawals in cash or short-term, lower-volatility investments, depending on their circumstances.
However, holding too much cash can reduce long-term growth potential and expose purchasing power to inflation. The appropriate reserve depends on spending needs, other income sources, and risk tolerance.
2. Diversify Your Portfolio
Diversification means spreading investments across different asset classes, industries, and securities. A portfolio might include stocks, bonds, and cash, with allocations based on the investor’s time horizon and financial needs.
Different investments may respond differently to market conditions. Although diversification cannot eliminate losses, it can reduce dependence on the performance of a single asset or sector.
3. Use a Flexible Withdrawal Strategy
A fixed withdrawal amount may become difficult to maintain after a significant market decline. A flexible approach allows retirees to adjust discretionary spending when portfolio values fall.
For example, someone might temporarily reduce travel spending or postpone a major purchase after a poor investment year. Essential expenses should be considered separately, since housing, food, and healthcare may be difficult to reduce.
The goal is to balance current spending with the need to preserve enough assets for future years.
4. Review Your Retirement Savings Before Retiring
The amount you have saved when retirement begins can influence how vulnerable you are to early market losses. A larger financial cushion may provide more flexibility, although it does not eliminate investment risk.
Review your retirement accounts, expected expenses, pension benefits, and other income sources before choosing a retirement date. Our guide to retirement savings by age explains common savings benchmarks and factors that can affect your retirement target.
5. Avoid Making Emotional Investment Decisions
Market declines can create pressure to sell investments quickly. However, making sudden changes based on fear may lock in losses or disrupt a carefully designed investment strategy.
Instead, establish a plan before retirement that explains how you will respond to different market conditions. This might include maintaining a cash reserve, reviewing your asset allocation, and deciding when discretionary withdrawals could be reduced.
A written plan can help you make decisions based on your financial needs rather than short-term market movements.
6. Consider the Role of Compounding
Investment growth over time can help retirement savings support future expenses, but withdrawals and market losses influence how much capital remains invested.
Understanding compound interest and how it grows your savings can help explain why preserving invested assets matters. Keep in mind that investment returns are variable, and market investments do not provide guaranteed compound growth.
Sequence-of-Returns Risk Example
Consider two hypothetical retirees who each begin retirement with $500,000 and withdraw $25,000 at the end of each year. For simplicity, assume one experiences a 20% loss followed by a 25% gain, while the other experiences the same returns in reverse order.
The first retiree experiences the loss while the portfolio is relatively large and continues withdrawing money from a reduced balance. The second experiences a gain first, potentially leaving more capital available before the later decline.
The precise results depend on the timing of withdrawals, investment returns, fees, and other factors. The example illustrates why the order of returns can affect retirement outcomes even when the same returns occur over the period.
Common Mistakes to Avoid
Retirees can make sequence-of-returns risk harder to manage by:
- Withdrawing too much during the early years of retirement.
- Keeping a portfolio that does not match their income needs or risk tolerance.
- Ignoring inflation and rising living expenses.
- Selling investments in a panic during market downturns.
- Assuming historical average returns guarantee future results.
- Failing to review spending and withdrawal plans after major market changes.
Avoiding these mistakes cannot guarantee that savings will last forever, but it can help reduce avoidable financial pressure.
Frequently Asked Questions
What is sequence-of-returns risk in simple terms?
It is the risk that the timing of investment gains and losses will affect how long retirement savings last, particularly when money is being withdrawn regularly.
When is sequence-of-returns risk most serious?
It is often most important during the early years of retirement, when a portfolio may be exposed to market losses while withdrawals are reducing its balance.
Can diversification eliminate sequence-of-returns risk?
No. Diversification may help manage investment risk, but it cannot prevent all losses or guarantee that a retirement portfolio will recover quickly.
Does sequence-of-returns risk affect people who are still working?
It can, but it is generally more consequential when someone is withdrawing money from a portfolio. Investors who are still contributing may have more flexibility to continue investing through market downturns.
Final Thoughts
Sequence-of-returns risk is an important consideration for anyone who depends on investments to fund retirement. Poor returns early in retirement can have a lasting impact when withdrawals reduce the amount of money available for future growth.
A combination of diversified investments, reasonable withdrawal rates, cash reserves, and flexible spending can help retirees manage this risk. Reviewing your retirement plan regularly and preparing for different market conditions can also improve financial flexibility.
No strategy can guarantee that retirement savings will last for a specific number of years. However, understanding how return timing affects your portfolio can help you make more informed decisions about retirement income and long-term financial security.
