What is sequence of returns risk & how does it impact retirement

As you set out on your retirement journey, you want to make the most of your money and stay on the road to financial stability. That's why, if you have investments as part of your retirement strategy, it's important to be aware of an unpredictable factor known as sequence of returns risk, or sequence risk. Ignoring this risk early in retirement can rapidly deplete your portfolio, increasing the likelihood of running out of money later in life. However, understanding it can help you stay on track to maximize your retirement withdrawals for the long term.

Sequence of returns risk, also known as sequence risk or SORR, is the danger that poor investment returns early in retirement, combined with ongoing withdrawals, will significantly reduce a portfolio's value and limit its ability to recover. Even if the average annual return over time is favorable, early losses can compound the problem because withdrawals lock in those losses, leaving less capital to benefit from future gains. This risk matters because it can jeopardize long-term financial security, especially in the first decade of retirement, when portfolio balances are largest and most vulnerable to market downturns.

Timing is critical with sequence of returns risk because the order in which investment gains and losses occur can drastically affect a retirement portfolio's longevity. Early losses, especially in the first years of retirement, are more damaging because withdrawals during a downturn lock in those losses, leaving less capital to recover when markets rebound. This reduced base means future gains have less chance for investment compounding. Compounding relies on growth building on prior gains, so a smaller base means each new return adds less momentum.

This formula gives a simple way to think about it: early negative returns + withdrawals = portfolio depletion.

Sequence of returns risk is greatest during the early withdrawal phase of retirement investments. Here's a breakdown of how this potential danger could result in long-term consequences:

• Early market downturns. If you experience a significant market downturn early in your retirement when you're making withdrawals from your investment portfolio, it can have a long-lasting effect on the portfolio's ability to recover.
• Impact on portfolio value. Poor returns in the initial years of your retirement can deplete your portfolio faster than anticipated, reducing the overall value available for future years.
• Increased withdrawal impact. When you make withdrawals for your living expenses during a market downturn, a higher percentage of the portfolio ends up being taken out, which can further diminish your remaining investment assets.
• Long-term consequences. Even if the market recovers in subsequent years, the portfolio may not fully recover due to the reduced principal resulting from earlier withdrawals.
• Potential exhaustion of assets. Sequence of returns risk increases the possibility you'll outlive your savings, especially if your early retirement years coincide with a prolonged bear market.

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Sequence of returns risk isn't just about the average return you get in retirement—it's about when those returns happen. Two retirees could earn the exact same average annual return over 20 years, but if one experiences big losses early on while taking withdrawals, their portfolio can deplete far faster than the other's. The following example compares two $1 million portfolios, both withdrawing $40,000 annually. In this example, both portfolios have the same average returns over 20 years but with opposite return sequences:

In this example, both retirees experience the same returns overall, just in a different order. The one with positive returns in the early years can better withstand later losses, allowing compounding to work in their favor. The retiree with early negative returns, however, locks in losses through withdrawals, reducing the base for future growth and accelerating portfolio depletion—despite the same average return. This demonstrates why early negative returns + withdrawals = portfolio depletion and why preparing for early market risk is crucial.

Mitigating sequence of returns risk in retirement involves adopting strategies to navigate market uncertainties and safeguard the sustainability of your financial plan. Here are some approaches that can be effective:

The 4% rule suggests beginning your annual retirement withdrawals at a rate of 4% of the initial portfolio value and then adjusting for inflation in subsequent years. This strategy aims to provide you with a steady income stream while minimizing the effect of market volatility on long-term sustainability.

A cash reserve strategy sets aside one to three years' worth of living expenses in highly liquid, low-risk accounts such as savings or money markets. This allows retirees to draw from cash instead of selling investments during market downturns, giving their portfolio time to recover.

This strategy involves dividing the investment portfolio into different "buckets" based on your time horizon and risk tolerance. Short-term buckets hold cash or conservative investments to cover immediate expenses, while long-term buckets remain invested for growth, allowing for potential recovery from market downturns.

The idea is that the income you need now or in the next few years is not invested in growth investments like stocks, which can be more volatile in the short term.

Delaying retirement or reducing withdrawals extends the investment horizon and reduces the number of years withdrawals are needed, lowering the chance of depleting assets early. Even a delay of a few years or a modest reduction in annual withdrawals can greatly improve long-term sustainability by letting compounding work in favorable market years.

A well-diversified portfolio spreads your investments across different asset classes, which may reduce the impact of poor performance in any single sector.² Diverse asset allocation helps manage risk and enhances your portfolio's resilience against market fluctuations.

For example, retirement assets that you don't need for at least 10 years can remain invested in riskier assets like growth stocks, while assets you need sooner can be invested in a mix of dividend stocks, funds and bonds.

Tax-efficient withdrawal strategies can help minimize the tax impact on retirement income. Strategically using a combination of taxable, tax-deferred and tax-free accounts can optimize after-tax income and preserve your overall portfolio.

Adopting a flexible approach to withdrawals allows you to adjust your spending based on market conditions. During favorable market periods, you may withdraw more, while in challenging times, you can tighten your belt to preserve the portfolio.

Periodic assessment and adjustment can help ensure your portfolio maintains its target asset allocation. This practice prevents overexposure to riskier assets and aligns your portfolio with your risk tolerance and financial goals.

Guaranteed income products, such as annuities and pensions, provide a predictable income stream that is not dependent on market performance. This stability helps cover essential expenses without needing to tap into volatile investments, effectively shielding a portion of retirement income from sequence of returns risk.

It's essential to consider longevity risk. As a retiree, you should plan for a longer retirement horizon and make sure your financial strategy accounts for potential medical expenses, long-term care and other factors that may arise in later years.

Understanding and addressing sequence of returns risk may help ensure your financial well-being throughout retirement. Having a well-structured investment strategy that considers the timing of market returns, especially during the important initial years of retirement, can help mitigate sequence of returns risk and maximize your retirement withdrawals.

To find a strategy that works for you, consider consulting with a Thrivent financial advisor.