Sequence of Returns Risk

Sequence of returns risk, sometimes called sequence risk, refers to the impact that the order of investment returns has on a portfolio from which withdrawals are being made. During the accumulation phase, the sequence of returns matters less because contributions are ongoing and there is time to recover from downturns. However, during the distribution phase of retirement, the combination of withdrawals and poor early returns can create a compounding negative effect that is difficult to overcome.

Consider two retirees who both experience the same average annual return over a 25-year period but in a different order. The retiree who experiences strong returns early and poor returns later could end up with significantly more money than the retiree who faces poor returns first. This is because early losses reduce the portfolio balance at the same time withdrawals are being taken, leaving fewer dollars to benefit from any subsequent recovery.

Research has shown that the returns experienced in roughly the first five to ten years of retirement have a disproportionate impact on portfolio sustainability. This period is sometimes called the "retirement risk zone" or "fragile decade." Understanding this concept may help retirees and pre-retirees think more carefully about asset allocation, withdrawal strategies, and the use of buffers or reserves.

Several strategies may help mitigate sequence risk. These include maintaining a cash reserve or bond allocation to cover near-term expenses during market downturns, using a dynamic withdrawal strategy that adjusts spending based on portfolio performance, considering annuity income for essential expenses, or employing a bucket strategy that segments assets by time horizon.