What Is Sequence of Returns Risk and Why Does It Matter?

Sequence of returns risk is a critical concept in financial planning, particularly for retirees or those nearing retirement. It refers to the negative impact on an investment portfolio when withdrawals coincide with market downturns, potentially affecting the longevity of savings. This risk underscores the importance of withdrawal timing, which can significantly influence financial outcomes.

Why Return Order Matters

The sequence of investment returns can have a significant impact on a portfolio’s performance, especially when withdrawals are involved. Negative returns early in retirement can reduce the portfolio’s value, making recovery difficult even if markets rebound later. Retirees relying on investments for income may be forced to sell assets at a loss to meet financial needs, further depleting savings.

For example, two retirees with identical portfolios and withdrawal rates may experience vastly different outcomes based solely on the timing of market downturns. A retiree facing a downturn early in retirement may see their portfolio depleted faster than one encountering downturns later. This highlights the need to plan for sequence of returns risk to ensure the sustainability of retirement savings.

Measuring This Risk

Understanding sequence of returns risk requires analyzing financial metrics that quantify its potential effects. These tools help investors anticipate and mitigate adverse market conditions.

Volatility Metrics

Volatility measures the degree of variation in investment returns over time and plays a key role in sequence of returns risk. Standard deviation is a common metric, indicating how much returns deviate from the average. A higher standard deviation signals greater volatility, which can intensify sequence risk. For instance, a portfolio with a standard deviation of 15% is more volatile than one with 10%, leading to larger fluctuations in value. The Sharpe ratio, which adjusts returns for risk, can also provide insight into whether a portfolio’s returns justify its volatility. A low Sharpe ratio may indicate a need for strategic adjustments to better balance risk and reward.

Drawdown Calculations

Drawdowns measure the decline from a portfolio’s peak to its lowest point before recovery. Understanding maximum drawdowns helps assess worst-case scenarios for investments. For example, a portfolio falling from $1 million to $700,000 experiences a 30% drawdown. This metric is particularly relevant for retirees, as significant drawdowns early in retirement can accelerate the depletion of savings. Historical drawdown analysis and stress testing—simulating adverse market conditions—can help evaluate a portfolio’s resilience and inform asset allocation decisions.

Distribution Patterns

The timing and amount of withdrawals from a portfolio significantly influence sequence of returns risk. The 4% rule, which suggests withdrawing 4% of an initial portfolio annually (adjusted for inflation), does not account for sequence risk. Withdrawing funds during a downturn can liquidate a larger portion of the portfolio, reducing future growth potential. To address this, retirees can adopt dynamic withdrawal strategies, such as adjusting withdrawal rates based on market conditions or using guardrails to set upper and lower withdrawal limits. These strategies balance financial needs with portfolio preservation.

Withdrawal Timings and Balances

The timing of withdrawals affects the sustainability of retirement savings. Required minimum distributions (RMDs) for certain retirement accounts, mandated by the IRS starting at age 73, may not align with optimal financial strategies. Tax-efficient withdrawal approaches, such as Roth conversions, can help manage taxable income and reduce the impact of RMDs. By converting traditional IRA funds to a Roth IRA, retirees can preserve balances and maintain favorable tax brackets.

An asset location strategy, which determines the order of withdrawals from taxable, tax-deferred, and tax-exempt accounts, is another tool for preserving portfolio balance. Drawing from taxable accounts first, for instance, allows tax-deferred accounts to continue growing. Regularly reassessing spending needs and adjusting withdrawal strategies—such as employing guardrails—can help retirees adapt to changing conditions and protect their savings.

Portfolio Composition and Sequencing

Portfolio composition is central to managing sequence of returns risk. Diversification, which spreads investments across asset classes like equities, fixed income, and alternatives, helps reduce the impact of market downturns. For example, bonds or real estate can provide stability during equity market declines, cushioning the portfolio from severe losses.

Balancing growth and income-generating assets is equally important. Growth assets, such as stocks, offer higher potential returns but also greater volatility. Income-generating assets, like bonds or dividend-paying stocks, provide stability and consistent cash flow. As retirement nears, gradually shifting from growth to income-focused investments can help preserve capital and ensure steady withdrawals.

Role of Market Variability in Retirement

Market variability—the fluctuations in asset prices and returns—poses unique challenges for retirees, who must manage withdrawals alongside unpredictable markets. Unlike during the accumulation phase, retirees cannot rely on dollar-cost averaging. Instead, they face “reverse dollar-cost averaging,” where selling investments during downturns can permanently reduce growth potential. For example, a retiree withdrawing $40,000 annually from a portfolio that declines by 20% in a year may need to sell more shares, leaving fewer assets to recover when markets rebound. Maintaining a buffer of liquid, low-volatility assets, such as cash or short-term bonds, can cover near-term expenses and mitigate this risk.

Inflation further complicates market variability by eroding purchasing power. During high inflation, fixed-income investments may deliver negative real returns, straining portfolios. To counteract this, retirees can incorporate inflation-protected securities like Treasury Inflation-Protected Securities (TIPS) or allocate funds to inflation-hedging assets such as commodities or real estate investment trusts (REITs). These strategies stabilize income and help preserve purchasing power during volatile markets.