Understanding and Managing Sequence of Returns Risk in Retirement

This concept is known as sequence of returns risk. It refers to the disproportionate impact poor investment returns may have when they occur early in retirement, particularly when portfolio withdrawals are happening at the same time. It is not just what returns you earn that matter, but when you earn them.

Explore how sequence of returns risk works, why it matters for retirement income planning, and strategies that may help investors build greater resilience into their retirement plans.

Key Takeaways

• Sequence of returns risk cannot be predicted or eliminated entirely, but planning may help manage its potential effects.
• Retirement income planning accounts for both market conditions and tax consequences.
• Flexibility in spending, withdrawals, and account selection can help preserve portfolio longevity.
• The appropriate strategy may change over time as markets, taxes, and personal circumstances change.
• Coordinating investment, income, and tax decisions can help create a more resilient retirement plan.

Why the Order of Returns Matters

Many investors assume that if two portfolios earn the same average return over a 30-year period, they will likely produce similar results. However, the order in which returns occur can make a significant difference once withdrawals begin.

During retirement, market declines can have a compounded effect. Not only does the portfolio experience losses, but withdrawals may require selling investments when account values are already depressed. Those assets are no longer available to participate in a future recovery.

As a result, poor returns early in retirement can have a lasting impact even when long-term average returns ultimately appear reasonable.

Same Returns, Different Outcome

Hypothetically, let’s assume two retirement portfolios start with $1 million each, use a 4% initial withdrawal rate, and increase withdrawals annually to adjust for inflation. Both portfolios average a 6.5% return over 30 years. The only difference was the order in which those returns occurred.

This example illustrates why average returns alone may not tell the full story. When stronger returns occur before significant withdrawals begin, portfolios may have a greater opportunity to grow. When market weakness arrives early in retirement, recovery can become much more difficult.

What a Probability of Success Score May Not Tell You

Retirement plans are often evaluated using Monte Carlo analysis and probability-of-success scores. While these tools can provide valuable insight, they may not fully capture the range of possible outcomes.

For example, a plan that falls short by one day and a plan that runs out of money many years early may both be categorized as unsuccessful outcomes. Yet those two situations could require very different responses and planning adjustments.  

This illustrates why it’s helpful for investors to think beyond simple success-or-failure labels. Consider the magnitude of potential shortfalls, as well as the flexibility available to respond if adjustments become necessary.

When Sequence Risk Is Greatest

Sequence of returns risk is often greatest during the five to 10 years surrounding retirement, including the final working years and the first years of portfolio withdrawals.

A market decline before retirement can reduce the amount available to support future spending. Once retirement begins, withdrawals may compound that effect by removing assets that would otherwise remain invested for a potential recovery. This may have an outsized impact on future portfolio sustainability.

Strategies to Help Manage Sequence of Returns Risk

While there is no way to predict market performance or eliminate sequence risk entirely, several planning strategies may help manage it.

Build Sources of Guaranteed Income

Social Security, pensions, and other income sources may help reduce dependence on portfolio withdrawals during periods of market volatility. In particular, delayed Social Security claiming may increase lifetime guaranteed income for some retirees.

If you have one, pension elections may involve similar trade-offs. A lifetime income option can provide more predictable cash flow, while a lump-sum option may offer greater flexibility or different legacy opportunities.

Maintain Liquidity and Reserves

Cash reserves, short-duration bonds, and other liquid assets may help provide flexibility during market downturns. Having assets available for spending can help reduce the need to sell equities at depressed prices.

Don't Solve One Risk by Creating Another

One common reaction to sequence risk is the desire to move entirely to cash and avoid market volatility altogether. While that approach may reduce short-term fluctuations, it can create other long-term challenges.

Holding excessive cash may increase inflation risk and longevity risk by limiting the portfolio's ability to grow over time. The objective is not to eliminate volatility at all costs. Rather, it is to build a plan capable of balancing multiple risks while supporting retirement spending goals.

Maintain a Diversified Portfolio

A diversified portfolio can balance near-term income needs with long-term growth. The appropriate asset allocation will depend on spending needs, time horizon, and risk tolerance. Lower-volatility assets may help fund upcoming withdrawals, while growth investments can help address inflation and longevity risk.

Manage Spending Flexibility

Retirees who can adjust discretionary spending during difficult market periods may place less pressure on their portfolios. Even modest adjustments can sometimes improve long-term outcomes. Don’t forget to revisit the withdrawal rate regularly, especially during changing circumstances.

Consider Working Longer

Working longer or continuing part-time employment, if feasible, may reduce near-term portfolio withdrawals, provide additional income, and shorten the period retirement savings must support. This can offer flexibility when markets are weak near retirement.

Coordinate Retirement Withdrawals and Taxes

Withdrawals from taxable, tax-deferred, and Roth accounts can have different tax consequences. Although drawing from taxable accounts first, tax-deferred accounts next, and Roth accounts last is a common starting point, there is no single withdrawal order that works for everyone.

The strategy may depend on current and future tax rates, Roth conversion opportunities, required minimum distributions (RMDs), Social Security taxation, Medicare premiums, charitable giving, and legacy goals. The broader objective is to manage taxes throughout retirement, not simply to minimize them in a single year.

What If Sequence Risk Has Already Occurred?

A difficult market early in retirement does not necessarily mean the plan has failed. It may mean the plan needs to adjust.

• Depending on the retiree’s circumstances, potential responses may include:
• Temporarily reducing portfolio withdrawals
• Using available cash or short-term reserves instead of selling depressed assets
• Revisiting part-time work or other employment options
• Rebalancing strategically rather than reacting to short-term market movements
• Harvesting investment losses where appropriate
• Evaluating whether market conditions create a Roth conversion opportunity

The appropriate response depends on the severity of the decline, the portfolio’s remaining resources, spending flexibility, tax circumstances, and the time available for recovery.

Build a Retirement Plan That Can Adapt

Sequence of returns risk cannot be predicted, and it cannot be completely avoided. But its effects can be planned for.

A well-designed retirement income strategy considers investment allocation, withdrawal decisions, tax planning, guaranteed income sources, and spending flexibility. As circumstances change, the plan may need to evolve as well.

The goal is not to predict the next market downturn. The goal is to build a retirement plan that can adapt when markets, spending needs, tax laws, or personal circumstances change.

How Focus Can Help You Manage Sequence of Returns Risk

Sequence of returns risk highlights the importance of coordinating investment, income, and tax decisions throughout retirement. Retirement outcomes often depend on more than market performance alone.

At Focus, we help clients evaluate retirement income decisions within the context of a comprehensive financial strategy. Whether you're approaching retirement, recently retired, or revisiting an existing income plan, thoughtful planning may help align your withdrawal strategy, tax planning, and investment approach with your long-term goals.  

Ready to start the conversation? Schedule a complimentary meeting with Focus to discuss how retirement income planning fits into your broader financial plan.