Sequence Risk Explained: Why Timing Matters in Retirement

Written by Steve Landers & Shara Cox

When planning for retirement, most people focus on how much they have saved and the returns their investments might achieve. However, there's another important factor that can significantly affect retirement outcomes: sequence risk.

Sequence risk, also known as sequence of returns risk, refers to the danger of experiencing market downturns in the early years of retirement while simultaneously drawing income from your portfolio.

Why Is Sequence Risk Important?

Two retirees may achieve the exact same average investment return over 20 years, yet one could run out of money much sooner than the other.

The difference often comes down to the order in which those returns occur.

When you're accumulating wealth, market downturns can be uncomfortable, but you generally have time to recover. In retirement, however, you're typically withdrawing money from your investments to fund your lifestyle. If markets fall early in retirement, those withdrawals can lock in losses and reduce the capital available to benefit from future market recoveries.

A Simple Example

Imagine two retirees each start with $1 million and withdraw the same amount every year.

Both portfolios achieve an average return of 6% over retirement. However:

  • Retiree A experiences strong returns in the first few years and weaker returns later.

  • Retiree B experiences several poor years at the beginning, followed by stronger returns later.

Despite having the same average return, Retiree B may end up with significantly less money because their portfolio was depleted during those early negative years.

This is sequence risk in action.

How Can You Manage Sequence Risk?

While sequence risk cannot be eliminated entirely, there are strategies that may help reduce its impact:

  • Keep a Cash/Defensive Asset Reserve

Holding a portion of your retirement savings in cash or defensive assets may provide a source of income during market downturns, reducing the need to sell growth investments at lower prices if a prolonged downturn occurred.

  • Maintain a Diversified Portfolio

Diversification across different asset classes can help reduce the impact of market volatility and avoid relying too heavily on one investment sector.

  • Review Your Exposure to Momentum investments with high Valuation Multiples

The higher the valuation multiple, the further it could potentially fall in a downturn. Try to include quality investments with strong earns and reasonable valuation multiples.

  • Seek Professional Advice

A well-structured retirement plan should consider not only expected returns but also the risks that can arise along the way. Stress testing different market scenarios can help identify potential vulnerabilities before they become problems.

The Bottom Line

Investment returns matter, but so does the order in which those returns occur. Sequence risk is one of the most significant challenges retirees face, particularly in the early years of retirement when withdrawals begin.

By having a suitable investment strategy, maintaining flexibility, and regularly reviewing your retirement plan, you can help improve your chances of achieving a sustainable and comfortable retirement.

If you'd like to understand how sequence risk could affect your retirement plans, our team at Salt Financial Group can help assess your strategy and ensure you're well prepared for the years ahead.

Jenni Anderson