Sequence of Returns Risk: Why the Order of Returns Matters in Retirement
Two retirees can earn the same average return over twenty years and end up in very different places. The reason is sequence of returns risk: the chance that poor market returns arrive early in retirement, right when you begin withdrawing money. During your working years, the order of returns matters less because you are adding to your accounts. Once withdrawals begin, a market decline in the first few years can have a lasting effect on how long your savings last.
For Wisconsin retirees and pre-retirees, managing sequence risk is an investment question and a tax question at the same time. Which accounts you draw from, how much cash you hold, and when you realize income all shape both your portfolio and your tax bill. Below, we explain how sequence risk works and the planning approaches worth discussing.
Start Here: A Complimentary Wealth and Tax Review
If retirement is a few years away or has already started, a clear picture of your income plan is the most useful first step. Compound offers a complimentary, no-obligation wealth and tax review that may include:
Your retirement income plan: expected spending, income sources, and how withdrawals are funded
Portfolio positioning: allocation, cash reserves, and how much is exposed to short-term market swings
Account mix: taxable, tax-deferred, and Roth balances and how they may be drawn down
Tax projections: how withdrawals, Social Security, and required distributions may interact over several years
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What Is Sequence of Returns Risk?
Sequence of returns risk describes how the timing of investment gains and losses affects a portfolio that is being drawn down. When you sell investments to fund living expenses during a decline, you sell more shares at lower prices. Those shares are no longer in the portfolio to benefit when markets recover. The earlier this happens, the longer the portfolio has to live with the smaller base.
Here is a simple way to picture it. Imagine two retirees with identical portfolios, identical withdrawals, and the same set of annual returns over twenty years, only in reverse order. The retiree who experiences the weak years first may finish with meaningfully less money, or run short, while the retiree who experiences the weak years later may finish with more. The average return is the same. The outcome is not.
This is why retirement withdrawal risk deserves its own place in a plan. Average return assumptions alone can hide how vulnerable a withdrawal strategy is to a poorly timed downturn.
When Is Sequence Risk Highest?
Sequence risk tends to be most significant in the years just before and just after retirement. Some planners call this the retirement "red zone." During this window, portfolios are often near their largest size, contributions are ending, and withdrawals are beginning. A decline at this point affects the largest dollar amount at the moment you are least able to wait it out.
Sequence risk may also matter more for retirees who:
Plan to withdraw a high percentage of their portfolio each year
Have few other income sources, such as a pension or rental income
Retire early, which means a longer period of withdrawals
Hold a concentrated position or an aggressive allocation going into retirement
Planning Approaches Worth Discussing
There is no single solution to sequence risk, and every approach involves tradeoffs. These are strategies that comprehensive wealth management often reviews.
1. A Cash and Short-Term Reserve
Holding a reserve of cash or short-term, high-quality bonds to cover a period of planned spending may allow you to avoid selling stocks during a downturn. This is sometimes called a bucket strategy. The tradeoff is that cash may earn less over time, so the size of the reserve is a judgment call based on your spending and comfort level.
2. Thoughtful Asset Allocation
An allocation designed around your income needs, rather than a generic model, can help reduce the impact of an early decline. Some retirees gradually adjust their allocation as they approach and move through retirement. Learn more about building a portfolio around your full financial picture.
3. Flexible Withdrawal Rules
A fixed withdrawal amount adjusted every year for inflation can be vulnerable in a weak market. Flexible approaches, such as pausing inflation increases after a down year or trimming discretionary spending temporarily, may help a portfolio recover.
4. Tax-Aware Withdrawal Order
This is where tax planning and preparation connects directly to sequence risk. Drawing from taxable, tax-deferred, and Roth accounts in a coordinated way may help you manage both market timing and your tax bracket. In a down year, for example, drawing from cash or from accounts that are not depressed, rather than selling investments at a loss, may make sense. A market decline can also be a moment to evaluate a Roth conversion strategy, since converting when values are lower may mean paying tax on a smaller amount.
5. Planning Around Required Distributions
Required minimum distributions from tax-deferred accounts begin at an age set by law and must be taken regardless of market conditions. Planning ahead for them, including strategies discussed in whether real estate can help lower RMDs, can reduce the chance of being forced to sell at the wrong time or into a higher bracket.
6. Other Income Sources
Coordinating the timing of Social Security, pension income, rental income, or part-time work may reduce how much you need from the portfolio in the early years of retirement, which can lower sequence risk.
See How the Order of Returns Can Change Outcomes
The Compound calculator lets you model how a hypothetical investment may grow over time under different assumptions. Results are hypothetical and for illustration only, but comparing scenarios can help frame a conversation about how withdrawals, returns, and taxes interact over a long retirement.
Why Sequence Risk Needs Both Wealth and Tax Planning
Sequence risk is usually discussed as an investment issue, but many of the most useful responses involve taxes: which account to draw from, when to convert, how to handle required distributions, and when to realize gains. When your investment advisor and your tax professional work separately, those decisions can fall between them. An integrated approach looks at portfolio strategy and multi-year tax strategy together. Read more about retirement planning in Wisconsin and what to look for in a financial advisor for retirees in Wisconsin.
Compound works with retirees, pre-retirees, executives, and business owners throughout Wisconsin, including Milwaukee, Madison, Green Bay, Appleton, Waukesha, Eau Claire, and La Crosse, as well as surrounding areas.
Planning your retirement income? Request a complimentary wealth and tax review to see how your withdrawal plan may hold up.
Frequently Asked Questions
What is sequence of returns risk in simple terms?
Sequence of returns risk is the risk that poor investment returns occur early in retirement, when you are withdrawing money. Selling investments during a decline can reduce how long your savings last, even if average returns over time are reasonable.
When does sequence risk matter most?
It is generally highest in the years just before and just after retirement, when portfolios are often largest and withdrawals are beginning.
How can retirees reduce retirement withdrawal risk?
Approaches to discuss include holding a cash reserve, adjusting asset allocation, using flexible withdrawal rules, coordinating other income sources, and drawing from accounts in a tax-aware order.
How do taxes relate to sequence of returns risk?
The accounts you draw from affect both your portfolio and your tax bill. Coordinating withdrawals, Roth conversions, and required distributions may help manage market timing and taxes together.
Does Compound work with retirees outside of Wisconsin?
Compound serves clients throughout Wisconsin and in surrounding areas. Availability of investment advisory services in a given state may depend on registration requirements.
Compound is a registered investment adviser. Registration does not imply a certain level of skill or training. This article is for informational and educational purposes only and should not be construed as personalized investment, tax, or legal advice. Tax laws are complex and subject to change. Strategies discussed may not be suitable for everyone, and there is no guarantee that any strategy will achieve its objectives or reduce taxes. Calculator results are hypothetical, are not guarantees of future results, and do not reflect any actual investment. Investing involves risk, including possible loss of principal. Diversification does not ensure a profit or protect against loss. Please consult your tax, legal, and financial professionals before acting on any information in this article. For more information, see Compound's Form ADV, available at adviserinfo.sec.gov.
About Compound Wealth
Compound Wealth works with business owners, entrepreneurs, professionals, and families with increasingly complex financial lives. The firm brings together tax planning, wealth management, client accounting services, and business transition advisory to provide a coordinated planning experience. By evaluating multiple aspects of a client's financial picture together, planning discussions may become more structured and aligned with long-term goals.
