What Is Sequence of Returns Risk? A Plain-Language Guide for Retirees

Retirement planning often focuses on average investment returns. But for retirees withdrawing money from their portfolios, the order those returns arrive can matter just as much as the average itself. This is called sequence of returns risk, and it is one of the most misunderstood parts of retirement income planning.

What Is Sequence of Returns Risk?

Sequence of returns risk is the possibility that the timing of investment gains and losses, not just their average, will affect how long a retirement portfolio lasts. Two people can earn the same average return over 20 years and end up with very different results, depending on whether the losses happened early or late.

While someone is still working and adding money to their accounts, the order of returns matters less. Contributions can buy more shares when prices are down, which softens the impact of a bad year. Once withdrawals begin, that dynamic can flip.

Why Average Returns Do Not Tell the Whole Story

Consider two portfolios that both average the same return over several years. If the higher-return years come first, the portfolio has more time and more assets working in its favor before any decline arrives. If the losses come first, withdrawals are drawn from a smaller base, and there is less left to benefit from the eventual recovery.

It’s a "double whammy." A market decline reduces the portfolio’s value, and a scheduled withdrawal on top of that decline reduces it further, at the exact time recovery becomes harder.

Why Does Sequence of Returns Risk Matter Most Near Retirement?

The years just before and after retirement are often the highest-risk window, because that is when the portfolio is typically at its largest dollar value, and withdrawals are just beginning. According to the U.S. Department of Labor, the average American spends roughly 20 years in retirement, which means this withdrawal period is not brief. A downturn that hits in year one or two of that stretch has more time to compound, and fewer years of contributions ahead to offset it.

What Is the "Retirement Red Zone"?

Financial planners often refer to the five years before and the five years after retirement as the "red zone." This is the period when a retiree typically has the most money at stake and the least amount of time to recover from a significant downturn before withdrawals begin in earnest. Retirement research from Morningstar notes that even a prolonged stretch of flat or low returns, not just a sharp market decline, can create meaningful sequence risk during this window.

How Can Retirees Help Manage Sequence of Returns Risk?

There is no single approach that removes this risk entirely, and any strategy involves trade-offs. That said, a few approaches are commonly discussed:

• Holding a cash reserve. Some retirees keep one to two years of planned withdrawals in cash or cash equivalents, so they are not forced to sell investments during a downturn.

• Adjusting withdrawal rates. Rather than withdrawing a fixed dollar amount every year regardless of market conditions, some retirees use a flexible approach that adjusts spending based on portfolio performance.

• Reviewing asset allocation. A portfolio’s mix of stocks and bonds can be revisited as retirement approaches, since a heavier equity allocation may carry more sequence risk.

• Coordinating with guaranteed income sources. Social Security and other steady income can reduce how much a retiree needs to withdraw from investments in a down year.

Morningstar’s most recent research estimated a starting safe withdrawal rate of 3.9 percent for a 30-year retirement, a figure that has moved between roughly 3.7 and 4.0 percent over the past several years as market conditions shifted. This is a general reference point, since the right withdrawal rate depends on individual circumstances.

Does Sequence of Returns Risk Affect People Who Are Still Working?

Sequence risk is generally less of a concern for people who are still contributing to their retirement accounts, since ongoing contributions can offset a down market by purchasing shares at lower prices. It becomes more relevant as retirement approaches and contributions slow or stop, which is why many advisors pay closer attention to portfolio structure in the five to ten years before a planned retirement date.

A Conversation Worth Having

Understanding sequence of returns risk is one part of building a retirement income plan. If you would like to talk through how this applies to your situation, scheduling an intro call with our team may be a helpful next step: https://mpmwealth.com/contact