Sequence-of-Return Risk: Why Your First Five Years Decide Everything

Market losses early in your retirement can have a lasting impact on your savings.

A market downturn early in retirement can shorten the life of your portfolio. Andrey_Popov/shutterstock

A market drop in your early years of retirement creates problems that go beyond a hit to your portfolio. Potentially, your portfolio may not last as long as you need.

At issue here is a phenomenon known as the sequence-of-returns risk. It says that the order and timing of poor investments can have a big impact on how long your retirement savings last.

But what is sequence-of-return risk, how does it work, and how can you reduce your exposure?

Sequence of Return

“Buy low, sell high” is common investment advice. But that may not always be possible. The long-term growth we associate with the stock market doesn’t happen in a straight line.

This means that you may be forced to sell an asset at a loss if you need access to your money. This can happen if you’re living off your retirement savings.

That’s where sequence-of-return risk becomes a major factor. According to Retirement Researcher, sequence-of-return risk focuses on the timing of market downturns and how early losses can reshape your entire income picture.

These losses can take place late in your working career or at the start of your retirement. At this point in your investment life, according to U.S. Bank, market downturns have a much more significant impact on your portfolio and your lifetime income strategy than otherwise. You don’t have the luxury of your investments recovering.

For example, take two retirees who each have a $1 million portfolio. They withdraw the same amount every year and have the same average annual return over a 30-year retirement.

The difference is the order of their yearly returns.

One retiree experiences a few down years early, followed by strong growth later. The other experiences strong growth early and down years at the end. The retiree who experienced turbulence in the first few years can run out of money earlier, even though the long-term average returns were the same. According to Retirement Researcher, the timing risk is the heart of the sequence problem.

According to wealth advisers The Madison Partners, the five years before and five years after retirement are the most vulnerable window.

How Sequence-of-Return Risk Works

When saving for retirement, market drops are opportunities. So long as you keep buying shares, a 25 percent market decline at age 35 is mostly noise. But when you retire, the math flips.

A 25 percent decline in year two of retirement means you’re locking in losses every time you sell shares to meet income needs.

According to Schwab, when you have to tap into your portfolio as it’s losing value, you have to sell more investments to raise the same amount of cash. This drains your portfolio and leaves fewer assets to generate growth during potential future recoveries. In other words, your portfolio never has a chance to recover.

According to wealth advisory firm The Madison Partners, this danger zone is referred to as the “retirement risk zone.” That’s because retirees who had poor returns in their first five years and didn’t cut spending were more likely to run out of money than those with strong early returns.

How to Reduce Sequence-of-Return Risk in Retirement

Although you can’t eliminate sequence-of-return risk, you can absorb it. You’ll want to build flexibility into your income plan. That way, an early bad stretch doesn’t force you to sell stocks at the wrong time.

Have a Cash or Short-Term Bond Buffer

Create some breathing room by keeping one to three years of planned withdrawals in cash or short-term bonds. That way, if there’s a downturn in your portfolio in the next year or two, you are not forced to sell investments for income.

For example, if you need $70,000 from your investments, keep $140,000 or more in stable assets to act as financial padding. The exact amount depends on your comfort level, income sources, and level of volatility you’re willing to tolerate.

Combine this with predictable sources of income, such as Social Security or pensions. Even a modest level of guaranteed income can make you feel confident and patient during unpredictable years.

Flexible Withdrawal Rules

Using rigid withdrawal plans can cause unnecessary damage. Instead of taking the same withdrawals each year, take less after a negative year.

Small adjustments can help preserve your portfolio.

For example, according to Retirement Researcher, a retiree who cuts withdrawals by 5 percent after a down year gives investments room to rebound without draining the portfolio too quickly.

Consider postponing a car replacement for one year or cutting back on travel. You don’t need to make life-altering changes; just manage your finances more tightly.

What Sequence-of-Return Risk Means for Your Plan

Sequence-of-return risk hides inside the timing of market swings instead of the averages, and it can change the entire landscape of your retirement.

Managing it isn’t about predicting markets, it’s about strategy. You must be willing to adjust when the unexpected happens.

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