Many retirees understand that market volatility is a normal part of investing. Stock markets have historically experienced periods of growth as well as periods of decline. While market fluctuations can affect investors at any stage of life, retirement introduces a unique challenge that often receives less attention: sequence-of-return risk.
For individuals who are actively withdrawing money from their portfolios, the timing of market gains and losses can matter just as much as the overall long-term return. Understanding sequence-of-return risk can help retirees better evaluate how market volatility may affect retirement income and long-term financial goals.
What Is Sequence-of-Return Risk?
Sequence-of-return risk refers to the possibility that poor market returns early in retirement may have a disproportionate impact on a portfolio’s ability to support future withdrawals.
Many investors focus on average rates of return over time. However, retirement income planning requires looking beyond averages.
Consider two retirees who experience the same average investment return over a twenty-year period. One retiree experiences several strong market years early in retirement, followed by weaker years later. The other experiences significant market declines during the first few years of retirement and stronger returns later.
Even though their average returns may be identical, their retirement outcomes could differ substantially.
This occurs because withdrawals made during periods of market decline can reduce the assets available to participate in future recoveries.
Why Sequence-of-Return Risk Is Different from Market Risk
Market risk refers to the possibility that investments may lose value due to market conditions.
Sequence-of-return risk is different because it focuses specifically on when those gains and losses occur.
During working years, investors are typically contributing money to their portfolios. Market downturns may allow them to purchase investments at lower prices.
Retirement changes this dynamic.
Instead of contributing assets, retirees are often withdrawing them. As a result, market declines can have a different impact than they did during the accumulation years.
The combination of withdrawals and declining account values can create challenges that may affect long-term retirement income.
A Simple Example
Imagine two retirees each begin retirement with a $1 million portfolio and withdraw the same amount annually.
Retiree A experiences strong market performance during the first several years of retirement.
Retiree B experiences significant market declines during those same years.
Although markets eventually recover, Retiree B may have already withdrawn a meaningful portion of assets while account values were depressed.
As a result, fewer assets remain available to benefit from future growth.
This example illustrates why sequence-of-return risk often receives significant attention in retirement income planning discussions.
The Early Retirement Years Are Critical
The first several years of retirement are often viewed as particularly important when evaluating sequence-of-return risk.
During this period, retirees may begin relying heavily on portfolio withdrawals to support living expenses.
If major market declines occur during these years, the combination of withdrawals and declining asset values can create additional pressure on a portfolio.
This does not mean retirees should avoid investing or attempt to predict market movements.
Instead, it highlights the importance of developing a thoughtful retirement strategy that considers how income will be generated under different market conditions.
The Role of Diversification
Diversification remains one of the most commonly discussed approaches to managing investment risk.
A diversified portfolio may include a combination of:
- Cash reserves
- Other asset classes
Diversification does not eliminate risk or prevent losses, but it may help reduce reliance on any single investment category.
When evaluating sequence-of-return risk, diversification can be one component of a broader strategy designed to address market volatility.
Income Sources Beyond the Portfolio
One way some retirees address sequence-of-return risk is by developing multiple sources of retirement income.
Examples may include:
- Social Security benefits
- Pension income
- Certain annuity products
- Treasury securities
- Certificates of deposit
- Investment portfolios
At Chapman Private Client Services, retirement planning often focuses on identifying essential expenses and evaluating how dependable income sources may help support those needs.
This approach may reduce the need to rely exclusively on portfolio withdrawals during periods of market volatility.
Maintaining Liquidity and Flexibility
Another consideration involves maintaining access to liquid assets.
Having cash reserves or other readily available resources may provide flexibility when markets experience temporary declines.
For example, some retirees maintain emergency reserves that may help cover unexpected expenses without requiring immediate portfolio withdrawals.
The appropriate amount of liquidity varies based on individual circumstances, but flexibility often plays an important role in retirement planning.
The Connection Between Taxes and Withdrawal Strategies
Taxes can also influence how retirees manage sequence-of-return risk.
Different account types receive different tax treatment.
Retirement assets may be held in:
- Taxable accounts
- Tax-deferred accounts
- Tax-free accounts
Having assets distributed across multiple tax categories may create additional flexibility when determining where withdrawals should come from during a particular year.
This concept, often referred to as tax diversification, is an important consideration in tax-aware retirement planning.
Planning for Longevity
Sequence-of-return risk becomes even more important when considering the possibility of a long retirement.
Many retirees may spend twenty to thirty years or more in retirement. A portfolio must often support income needs throughout that entire period.
Market declines that occur early in retirement can have effects that extend for many years.
This is one reason retirement planning often focuses not only on investment performance, but also on withdrawal strategies, tax considerations, and income planning.
Building a Comprehensive Retirement Strategy
At Chapman Private Client Services, retirement planning begins with understanding each client’s goals, concerns, and priorities.
A comprehensive plan considers:
- Retirement income needs
- Tax planning opportunities
- Investment strategy
- Market volatility
- Healthcare expenses
- Legacy objectives
Rather than focusing solely on investment returns, the planning process evaluates how various factors work together to support long-term goals.
This broader perspective can help retirees better understand the challenges and opportunities that may arise throughout retirement.
Addressing Sequence-of-Return Risk in Retirement
Sequence-of-return risk is an important consideration for retirees because the timing of market returns can influence how long retirement assets may last. By understanding how withdrawals, market volatility, taxes, and income sources interact, retirees can make more informed decisions about their financial future.
If you would like to discuss sequence-of-return risk and how it may affect your retirement plan, contact Chapman Private Client Services. Our team can help you evaluate your current financial picture, review retirement income strategies, and develop a personalized roadmap aligned with your retirement, lifestyle, and legacy goals. We look forward to hearing from you!
