Sequence of Returns Risk: Why It Matters for Retirement Withdrawals

Sequence of returns risk is a critical concept for anyone planning for or currently in retirement, especially when it comes to understanding withdrawal strategies. It refers to the risk that the order in which your investment returns occur can significantly impact the longevity of your retirement savings, even if the average returns over time are positive. It’s not simply about the overall average return you achieve throughout your retirement; it’s about the timing, particularly in the early years of withdrawals.

Imagine two retirees, both starting retirement with the same portfolio value and both expecting to withdraw the same percentage each year. Both portfolios earn the same average annual return over their retirement period. However, Retiree A experiences strong positive returns in the initial years of retirement, followed by less favorable returns later. Retiree B, on the other hand, experiences poor or negative returns in the early years, followed by stronger returns later. Even though their average returns are identical, Retiree A is likely to have a much more comfortable and longer-lasting retirement than Retiree B. This difference arises because of sequence of returns risk.

When you begin taking withdrawals from your retirement portfolio, especially in the early years, negative returns can be particularly damaging. If the market experiences a downturn early in your retirement, and you are simultaneously drawing down funds, you are essentially selling investments at lower prices to meet your income needs. This locks in losses and reduces the base from which your portfolio can recover and grow in subsequent years. Conversely, if you experience positive returns early on, your portfolio can grow even as you withdraw, building a stronger foundation to withstand potential downturns later in retirement.

This risk directly impacts withdrawal strategies because many common approaches, like the popular “4% rule,” are implicitly based on historical average returns. The 4% rule, for example, suggests withdrawing 4% of your portfolio in the first year of retirement, and then adjusting that dollar amount for inflation each subsequent year. While historically, this strategy has often been considered sustainable over a 30-year retirement period, it’s crucial to understand that these analyses are often based on long-term average returns. They don’t fully account for the potentially devastating effect of a poor sequence of returns, especially in the first decade of retirement.

A sequence of negative returns early in retirement can force you to withdraw a larger percentage of your remaining portfolio just to maintain your desired income level. This accelerates the depletion of your savings and makes it significantly harder for your portfolio to recover, even if market conditions improve later. In contrast, a positive sequence early on allows your portfolio to grow, providing a buffer against future market volatility and potentially allowing for larger withdrawals later without jeopardizing long-term sustainability.

To mitigate sequence of returns risk, retirees should consider several strategies when planning their withdrawals:

• Flexible Withdrawal Strategies: Instead of rigidly adhering to a fixed percentage withdrawal, consider a more flexible approach. This might involve adjusting withdrawal amounts based on portfolio performance and market conditions. In years with strong returns, you might withdraw slightly more, while in years with poor returns, you might withdraw less or even consider delaying some withdrawals if possible.
• Conservative Asset Allocation in Early Retirement: While a growth-oriented portfolio is important for long-term accumulation, shifting towards a slightly more conservative asset allocation as retirement approaches and in the early years of retirement can help buffer against early negative returns. This may involve increasing the allocation to less volatile assets like bonds, although it’s crucial to maintain some growth potential to combat inflation and ensure long-term portfolio sustainability.
• Contingency Planning and Emergency Funds: Having a separate emergency fund or other readily accessible assets can provide a cushion during periods of market downturns. This can reduce the need to withdraw from retirement accounts when investment values are low, allowing your portfolio time to recover.
• Consider Guaranteed Income Sources: Annuities or other forms of guaranteed income, like Social Security, can provide a stable income floor, reducing reliance on portfolio withdrawals and thus lessening the impact of sequence of returns risk on the overall retirement income plan.
• Delay Retirement (If Possible): If you experience a significant market downturn close to your planned retirement date, and if it is feasible, delaying retirement for a year or two can allow your portfolio more time to recover before you begin withdrawals.

Understanding sequence of returns risk is paramount for effective retirement planning. It highlights that simply focusing on average returns is insufficient. Retirees need to proactively consider the potential impact of the order of returns, especially early in retirement, and adopt withdrawal strategies and portfolio management techniques that can help mitigate this risk and increase the likelihood of a financially secure and comfortable retirement.