You've spent decades building your nest egg. You've watched it grow through market ups and downs, knowing that over the long run, investments have historically recovered and climbed higher. So when you finally reach retirement, you might expect that same logic to carry you through.
But here's where retirement can change the rules: Once you start drawing down your savings, the order in which your investment returns occur matters. This is known as sequence-of-returns risk, and planning for it can help protect the longevity of your retirement savings.
What Is Sequence-of-Returns risk?
Sequence-of-returns risk refers to the danger that a significant market downturn early in retirement, combined with ongoing withdrawals, can have a lasting negative impact on your portfolio, even when the market recovers.
Here's a simple way to think about it. Imagine two retirees who both average a 6% annual return over 20 years. One retiree experiences strong returns early and weaker returns later; the other experiences the opposite: weaker returns early, followed by strong returns later.
Even though their average return is identical, the retiree who faces losses early — while simultaneously making withdrawals — could end up with significantly less money, even running out entirely.
That's because early losses reduce your portfolio's size, even as you're drawing from it. When markets eventually rebound, there's less money left to benefit from the recovery. The math simply doesn't work the same way it did during your accumulation years when your portfolio had a longer timeline to recover.
Why This Risk Is Unique to Retirees
During your working years, market volatility is actually something you can take advantage of. A down year means you're buying more shares at lower prices. This dynamic works in your favor when you're contributing to your portfolio.
In retirement, the opposite applies. When you sell shares to fund living expenses during a down market, you're locking in losses and reducing the number of shares available to recover when the market bounces back. The longer a rough stretch lasts early in retirement, the more pronounced the impact can be.
This doesn't mean retirement investing is inherently precarious or that a volatile quarter should cause alarm. It does mean that an informed strategy for managing withdrawals and portfolio exposure becomes important once you stop working.
Practical Ways to Manage the Risk
The good news is that planning for sequence-of-returns risk can make it more manageable. A few strategies that can help:
Maintain a cash reserve. Keeping one to two years of living expenses in cash or short-term, stable assets means you don't have to sell investments at depressed prices when markets dip. You can draw from this buffer while your portfolio has time to recover.
Build a diversified, income-aware portfolio. A portfolio designed specifically for your retirement income needs, with appropriate exposure to bonds, dividend-paying equities, and other income sources, can help mitigate volatility and provide stability during down markets.
Consider flexible spending. Having the ability to tighten spending modestly in early retirement, even temporarily, could make a meaningful difference in long-term portfolio sustainability.
Coordinate your income sources strategically. Timing decisions around Social Security, required minimum distributions (RMDs), and portfolio withdrawals can reduce how much you need to pull from investments in any given year, especially during volatile markets.
Think of retirement as a sequence of phases: Early, mid, and late retirement often call for different investment approaches. Planning for this progression helps keep your money working for you through each stage.
Ongoing Planning Is Key
Sequence-of-returns risk is one reason why retirement planning isn't a "set it and forget it" exercise. Markets change. Spending needs change. Life changes. Ongoing monitoring and adjustments are what keep a plan on track through all of those shifts.
This is the kind of risk we model for our ongoing financial planning clients. By stress-testing your plan against a range of market scenarios, including unfavorable early-retirement sequences, we help create an income strategy designed to hold up not just in best-case scenarios, but in realistic, challenging ones too.
If you'd like to talk through how sequence-of-returns risk might affect your retirement picture, we'd welcome the conversation. Schedule a call with a fee-only, fiduciary advisor today and take the next step toward a retirement strategy built around your actual life.