Key Takeaways:
- Return timing matters as much as average returns. A downturn early in retirement, while you're withdrawing money, can hurt you more than the same downturn hitting later.
- Your risk depends on how much income relies on your portfolio. Steady sources like Social Security or a pension ease the pressure; heavy reliance on withdrawals increases it.
- Splitting your portfolio and staying flexible protects your income. Keep cash for near-term spending, growth assets for the long run, and adjust withdrawals when markets dip.
Retirement income planning is not only about how much your portfolio earns over time. It is also about when those returns happen. Two retirees can start with the same amount of money, take the same withdrawals, and earn the same average return over retirement. But if one experiences strong returns early and the other experiences poor returns early, their outcomes can look very different. That difference is called “sequence of returns risk.”
Sequence of returns risk becomes especially important once withdrawals begin. A market downturn early in retirement can be harder to recover from because money is leaving the portfolio at the same time investments may be losing value.
This does not mean retirees should avoid market risk altogether. Growth can still play an important role in helping a portfolio keep up with inflation. But it does mean your retirement income strategy should account for market timing, withdrawal needs, and the flexibility built into your plan.
What Is Sequence of Returns Risk?
Sequence of returns risk is the risk that poor investment returns happen at a damaging point in your retirement timeline. The order of investment returns can matter just as much as the average return, especially once withdrawals begin. During your working years, market downturns may feel uncomfortable, but regular contributions can help. If you are still saving, you may be buying investments at lower prices during a down market.
Retirement is different. Once withdrawals begin, a downturn can create more pressure. If your portfolio loses value and you still need income, you may have to sell more shares to generate the same dollar amount. That can leave fewer shares available to benefit from a future recovery.
For example, one retiree may experience strong returns in the first several years of retirement and negative returns later. Another retiree may experience the same returns in reverse order. Even if both portfolios average the same return over time, the retiree who experiences early losses may face more pressure.
That is why sequence of returns risk is a major retirement income concern. It is not just about market performance. It is about market performance combined with ongoing withdrawals.
Why Early Retirement Losses Can Hurt Future Income
The first several years of retirement can be especially sensitive because your portfolio may be near its highest value while you begin withdrawing. If the market performs well early in retirement, the portfolio may have more room to support future withdrawals and absorb later downturns. But if the market declines early, repeated withdrawals can make the damage harder to repair.
Selling investments during a downturn can reduce the number of shares that remain invested. If the market later recovers, your portfolio may not fully participate in that recovery because part of the portfolio was already sold to fund spending.
Inflation can add another layer of pressure. If everyday costs rise while your portfolio is still recovering, you may need to withdraw more just to maintain the same lifestyle. Higher withdrawals during a weak market can increase the risk of portfolio depletion.
Early losses do not automatically mean a retirement plan will fail. But they can require adjustments. The sooner a plan accounts for that risk, the more options a retiree may have.
Measure How Exposed Your Retirement Income Is
Sequence of returns risk becomes more important when a large share of your retirement income must come from portfolio withdrawals. If Social Security, pensions, annuities, rental income, part-time work, or other recurring income sources cover most of your essential expenses, your portfolio may face less pressure during a downturn. But if your portfolio funds most of your lifestyle, poor early returns can have a greater impact.
A good starting point is to identify how much income your portfolio actually needs to provide. First, list your reliable sources of income. This may include Social Security, pension payments, annuity income, rental income, business income, or part-time work. Then, compare those income sources against your expected spending. It can help to separate expenses into two categories: essential and discretionary.
Essential expenses may include housing, utilities, groceries, insurance, taxes, and health care. These costs usually need steady support. Discretionary expenses may include travel, gifts, home upgrades, dining out, hobbies, and lifestyle purchases. These expenses may have more room to adjust during weaker markets.
This distinction matters because retirees who rely heavily on portfolio withdrawals for essential expenses may need more protection from early market losses. Retirees with stronger, dependable income sources or more flexible spending may have more room to adapt.
Structure the Portfolio to Protect Income During Downturns
Portfolio structure can help reduce the need to sell growth assets when markets are down. The goal is not to avoid investment risk completely. Becoming too conservative can create a different kind of risk if retirement lasts 20, 30, or more years. A portfolio still needs growth potential to help keep up with inflation and support long-term income needs.
The key is to assign different parts of the portfolio distinct roles. Some assets may be used for near-term spending. Others may be invested for long-term growth. This type of structure can give retirees more flexibility when markets are volatile.
Near-Term Spending Assets
Near-term spending assets are designed to help fund withdrawals during the early years of retirement or during market downturns. This may include cash reserves, money market funds, short-term bonds, or other conservative holdings, depending on the retiree’s needs and risk profile. The purpose is to provide a source of income without selling stocks or other growth-oriented assets during a downturn.
A cash reserve can be especially helpful when markets are weak. Instead of selling investments that have declined in value, retirees may be able to draw from cash or conservative holdings while giving growth assets more time to recover.
The right size of this near-term bucket should be based on actual portfolio withdrawal needs, not a generic dollar amount. For example, a retiree who receives most of their income from Social Security and a pension may only need a modest amount from their portfolio each year. Another retiree who relies heavily on portfolio withdrawals may need a larger near-term reserve.
Long-Term Growth Assets
Long-term growth assets are the part of the portfolio designed to support retirement over many years. This may include stocks or other growth-oriented investments. While these assets can be more volatile, they can also help the portfolio keep pace with inflation and support long-term durability.
Avoiding market risk entirely may feel safer in the short term, but it can create problems over a long retirement. Inflation, health care costs, taxes, and longevity can all increase the amount of income a retiree needs over time. A retirement income plan needs to balance stability and growth.
Rebalancing can also play an important role. After stronger market periods, gains from growth assets may be used to refill near-term spending reserves. During weaker markets, retirees may rely more on cash or conservative holdings to avoid selling growth assets at lower values.
Adjust Withdrawals When Sequence of Returns Risk Shows Up
Withdrawal flexibility can help reduce the long-term damage caused by poor early returns. A retirement income plan should define how spending may adjust before market stress creates pressure. It is much easier to make thoughtful decisions when the plan is built in advance rather than during a market downturn.
Adjustments do not always need to be dramatic. In some cases, small temporary changes can help preserve long-term portfolio health. For example, a retiree may reduce discretionary spending for a year, pause a large purchase, use cash reserves, or adjust which account withdrawals come from. The right decision depends on the portfolio, tax situation, spending needs, market conditions, and available income sources.
Spending Guardrails
Spending guardrails are rules or guidelines that help retirees know when to adjust withdrawals. For example, a plan may define when withdrawals should be reduced, paused, or shifted toward cash reserves during weaker markets. It may also identify which spending categories should be adjusted first.
Discretionary expenses are often the first place to look. Travel, gifts, large purchases, home upgrades, and lifestyle spending may have more flexibility than essential costs like housing, insurance, groceries, and health care.
Annual withdrawal reviews can also help. These reviews may compare portfolio value, current withdrawal rate, spending needs, inflation, tax exposure, cash reserves, and market conditions. If the portfolio is ahead of expectations, spending may be able to continue or increase. If the portfolio is under pressure, the plan may call for temporary adjustments. Guardrails can help retirees avoid emotional decisions and keep the income plan aligned with long-term goals.
Account Selection During Downturns
The accounts you withdraw from can also affect your retirement income plan. Taxable brokerage accounts, traditional IRAs, 401(k)s, Roth accounts, HSAs, and cash reserves can each create different tax and liquidity results. During a downturn, account selection may become even more important because the goal is often to avoid unnecessary taxable income or poorly timed asset sales.
For example, taking money from a traditional retirement account may create ordinary taxable income. Selling investments in a taxable account may create capital gains or losses. Roth accounts may provide tax-free income if qualified withdrawal rules are met. HSAs may offer tax advantages when used for qualified medical expenses. There is no universal withdrawal order that works for everyone.
The right account selection may depend on required minimum distributions, Medicare premium exposure, capital gains, tax-loss harvesting opportunities, charitable giving goals, health care costs, Roth conversion planning, and current market conditions.
Sequence of Returns Risk FAQs
1. What is sequence of returns risk?
Sequence of returns risk is the risk that poor investment returns happen at a damaging time, especially early in retirement when withdrawals are beginning.
2. Why does sequence of returns risk matter in retirement?
It matters because retirees are often taking money out of their portfolios for income. If the market declines while withdrawals continue, the portfolio may lose value faster and have fewer assets available to benefit from a future recovery.
3. How can sequence of returns risk affect retirement income?
Sequence of returns risk can affect how long a portfolio lasts and how much income it can support. Poor early returns may force retirees to reduce withdrawals, adjust spending, use cash reserves, or change account withdrawal strategies.
4. Can cash reserves help reduce sequence of returns risk?
Cash reserves can help provide a source for near-term withdrawals during market downturns. This may reduce the need to sell growth assets when they are down.
5. Should retirees change withdrawals during a market downturn?
In some cases, yes. Temporarily reducing withdrawals, delaying large discretionary expenses, or using cash reserves may help reduce long-term pressure on the portfolio.
6. How often should a retirement income plan be reviewed for sequence of returns risk?
A retirement income plan should generally be reviewed at least annually and after major life changes. Reviews can help assess portfolio value, withdrawal rate, spending needs, tax exposure, cash reserves, and market conditions.
Get Help Building a Retirement Income Plan That Accounts for Sequence of Returns Risk
Sequence of returns risk planning should connect investments, withdrawals, cash reserves, taxes, income sources, and spending flexibility. A retirement income plan should not rely only on average market returns or a simple withdrawal percentage. It should test how the plan may respond to different market environments, changing tax situations, inflation, Social Security timing decisions, health care costs, and spending adjustments.
The goal is to create a plan that can support current spending while preserving flexibility during difficult market periods. At The Capital Group, we help individuals and families think through the moving parts of retirement income planning, including investment strategy, withdrawal planning, account selection, Social Security timing, tax considerations, and long-term risks.
If you are preparing for retirement or already taking withdrawals, we invite you to schedule a complimentary consultation to discuss how your retirement income plan can account for sequence of returns risk.