Many retirees spend years focused on growing their retirement savings. However, once retirement begins, another factor may become increasingly important: the order in which investment returns occur. This concept is known as sequence of returns risk, and it can have a meaningful impact on retirement income planning. Understanding how sequence of returns risk works may help retirees make more informed decisions about withdrawals, spending, and overall retirement planning.
What Is Sequence of Returns Risk?
Sequence of returns risk refers to the possibility that negative investment returns occur early in retirement while withdrawals are being taken from a portfolio. Interestingly, two retirees could experience the same average rate of return over time but have different outcomes depending on when positive and negative returns occur. For retirees who are regularly withdrawing money from their accounts, the timing of market gains and losses can matter.
Why Does the Order of Returns Matter?
During your working years, market declines may be less impactful because you are typically contributing money to your retirement accounts. Retirement often introduces a different dynamic. Instead of adding money to a portfolio, retirees frequently begin taking withdrawals to help support their income needs. If market declines occur during the early years of retirement, withdrawals may reduce the number of shares or investments remaining in the account. As a result, the portfolio may have fewer assets available to participate in future market recoveries. This is one reason sequence of returns risk is often discussed in retirement income planning.
A Simple Example
Consider two retirees who each begin retirement with the same portfolio value and withdraw the same amount each year. Over a 20-year period, both retirees experience the same average investment return. However, one retiree experiences several years of negative returns early in retirement, while the other experiences those same negative returns later. Although the average return is identical, the retiree who experienced losses earlier may see a different account balance over time because withdrawals occurred during periods of market decline. This example illustrates why average returns alone may not tell the full story.
Factors That May Influence Sequence of Returns Risk
Several factors can affect how sequence of returns risk impacts a retirement plan, including:
- Withdrawal rates
- Portfolio allocation
- Market conditions
- Retirement spending needs
- Other sources of income, such as Social Security or pensions
Because every retiree's situation is different, the impact of these factors can vary from one household to another.
How Retirees May Address Sequence of Returns Risk
While no strategy can eliminate market risk, retirees often evaluate ways to manage the potential impact of market volatility during retirement. Examples may include:
- Maintaining an appropriate asset allocation based on individual goals and risk tolerance
- Reviewing withdrawal strategies
- Coordinating investment decisions with retirement income planning
- Evaluating other available income sources
- Periodically reviewing financial plans as circumstances change
The approach that may be appropriate for one retiree may not be appropriate for another.
Sequence of Returns Risk Is About More Than Investments
Although sequence of returns risk is often discussed as an investment topic, it also connects to other areas of retirement planning. Income planning, tax strategy, healthcare expenses, and spending flexibility may all influence how retirees navigate market volatility. This is one reason many retirees choose to evaluate their investments within the context of a broader retirement plan rather than viewing investment decisions in isolation.
Final Thoughts
Sequence of returns risk is a concept that highlights the importance of timing during retirement. While retirees cannot control market performance, understanding how withdrawals and market fluctuations interact may provide additional perspective when evaluating a retirement strategy. Retirement planning involves more than pursuing investment returns. It also involves understanding the factors that may affect how those returns are experienced over time.