Picture two couples retiring at age 65.
Both have accumulated $1 million in investment assets. Both expect to supplement Social Security with $60,000 annually from their portfolios. Both have similar investment allocations.
And over the first five years of retirement, both portfolios experience exactly the same annual investment returns.
Yet at the end of those five years, one couple has roughly $148,000 more remaining than the other.
How is that possible? The answer involves one of the most important, and most frequently misunderstood, risks in retirement planning. It's called sequence-of-returns risk, and understanding it can genuinely change how you think about retirement income.
The Average Return Doesn't Tell the Whole Story
During our working years, we generally invest money expecting it to grow over time. Markets fluctuate, sometimes dramatically, but that isn't necessarily a problem when we're regularly contributing and have decades before retirement. Market declines can even create opportunities to buy investments at lower prices.
Retirement changes the equation. Instead of regularly adding money to your investments, you begin taking money out. And that creates an important difference: when you're withdrawing from a portfolio, the order in which investment returns occur can significantly affect your financial outcome.
Let me walk you through an example.
Two Retirements, Two Different Outcomes
Consider two hypothetical retirees, each beginning retirement with a $1 million portfolio. Both withdraw $60,000 at the end of each year. Over their first five years, they experience the same five annual investment returns, just in reverse order.
Retiree A: Year 1, -20%. Year 2, -10%. Year 3, +10%. Year 4, +15%. Year 5, +25%. Portfolio after five years: $736,988.
Retiree B: Year 1, +25%. Year 2, +15%. Year 3, +10%. Year 4, -10%. Year 5, -20%. Portfolio after five years: $885,132.
Both retirees began with $1 million. Both withdrew $300,000 over five years. Both experienced exactly the same investment returns. But Retiree B finished with roughly $148,000 more.
Why? Because Retiree A experienced significant losses early in retirement, while Retiree B experienced those same losses later. This hypothetical illustration assumes annual withdrawals of $60,000 at year-end, no taxes or investment fees, and no adjustment for inflation. It's meant to demonstrate sequence-of-returns risk, not to predict investment performance or establish an appropriate withdrawal rate for anyone's actual circumstances.
Why Early Losses Are Particularly Dangerous
Suppose your portfolio declines 20% during your first year of retirement. Your $1 million becomes $800,000. Now you withdraw $60,000 to support your lifestyle, leaving $740,000.
Even if the market later recovers, your portfolio has fewer dollars participating in that recovery, because some of your investments were sold to fund retirement expenses while prices were depressed. Those dollars are no longer invested.
Now think about the retiree who experiences strong returns early in retirement instead. Their portfolio may build additional value before ever facing a significant decline. Even though both investors eventually experience the same returns, the timing of withdrawals relative to those returns changes the outcome.
Here's the part I really want you to notice: without withdrawals, the order of those five annual returns wouldn't change the ending portfolio value at all. Both hypothetical portfolios would finish at $1,138,500. It's the combination of market fluctuations and ongoing withdrawals that creates sequence-of-returns risk. That's exactly why retirement investing calls for a different perspective than accumulation investing.
Your Retirement Date Matters, But You Can't Control It
Someone retiring right before a prolonged bull market may have a very different financial experience than someone retiring right before a major decline. Neither retiree necessarily made a better investment decision or selected superior investments. They simply retired into different market environments. This is sometimes called retirement timing risk.
Unfortunately, there's no reliable way to predict which environment you'll walk into. Waiting for the perfect market to retire isn't a practical solution either, markets can stay expensive for years, and significant declines can show up without warning.
Instead, the goal should be building a retirement-income strategy that doesn't depend on favorable market conditions during your first few years.
The Role of a Cash Reserve
One way to address sequence-of-returns risk is maintaining an appropriate amount of liquidity.
Imagine a retiree who needs $5,000 a month from their investments. If every dollar is invested in volatile assets, those monthly withdrawals may require selling investments regardless of market conditions, which gets uncomfortable fast during a substantial decline.
A dedicated reserve of cash or other relatively stable, liquid assets may provide an alternative source of spending. Instead of selling stocks during a difficult market, the retiree may be able to draw from those reserves instead. This doesn't eliminate investment risk, and holding excessive cash creates its own challenges, including inflation risk and the opportunity cost of missing potential growth. The goal is balancing liquidity with long-term investment needs. Cash isn't necessarily there to generate the highest return. Sometimes its job is simply giving your long-term investments time to recover.
Not Every Dollar Has the Same Job
This leads to another useful concept I come back to often. Your entire portfolio doesn't need to serve the same purpose.
Think about dividing retirement needs into three broad time horizons. Near-term needs are money required for current spending, anticipated large purchases, and unexpected expenses, these dollars generally benefit from greater liquidity and stability. Intermediate-term needs are money expected to support spending several years into retirement, which may emphasize a balance of income, stability, and moderate growth. Long-term needs are money intended to support spending 10, 15, or even 20 years out, which may require more growth potential to help offset inflation.
This doesn't require three separate accounts. It's a way of thinking about how different assets contribute to your overall strategy. The important principle: money needed next month shouldn't necessarily be invested the same way as money needed 20 years from now.
Spending Flexibility Is Another Form of Risk Management
Investment allocation isn't the only lever here. Your spending decisions matter too.
Say a retired couple spends $120,000 annually, with $85,000 covering essential expenses like housing, food, insurance, healthcare, and taxes, and the remaining $35,000 supporting travel, entertainment, hobbies, and other discretionary activities. If markets decline substantially, that household may have room to temporarily adjust spending without meaningfully compromising their financial security. Maybe an expensive vacation gets postponed. Maybe a home renovation waits another year. Those decisions can reduce portfolio withdrawals during unfavorable markets.
This is sometimes called a dynamic withdrawal strategy, rather than increasing withdrawals automatically every year, retirees periodically evaluate spending against portfolio performance and remaining resources. That flexibility can be genuinely valuable, but it has to be realistic. A household whose spending is almost entirely essential expenses has less flexibility than one with substantial discretionary spending, and understanding that distinction before you retire is an important part of planning.
Social Security Can Help Create Stability
Social Security also plays an important role in managing retirement risk. Unlike investment withdrawals, Social Security benefits aren't directly dependent on daily stock market performance, and benefits generally receive annual cost-of-living adjustments. That makes Social Security a valuable piece of a retirement-income strategy.
For clients with real assets, decisions about when each spouse claims benefits can affect how much dependable income is available throughout retirement. Delaying benefits may increase monthly payments, but it can also require larger portfolio withdrawals during the years before benefits begin. Those competing considerations deserve careful evaluation, and the right claiming strategy depends on health, longevity expectations, marital status, other income sources, and overall financial resources. The point is that Social Security decisions and portfolio withdrawal decisions should be evaluated together, not separately.
What About Investors With $2 Million or More?
It's tempting to think sequence-of-returns risk becomes irrelevant once you've built substantial wealth. But the size of the portfolio is only one part of the equation.
Consider two households. One has a $1.5 million portfolio and needs $40,000 annually from investments. Another has $3 million but requires $180,000 annually to support its lifestyle. The second household has twice the assets, but a substantially higher initial withdrawal percentage, which can make it more sensitive to unfavorable returns early in retirement.
Retirement security depends on the relationship between your assets and the demands placed on them, not simply your net worth. For households with substantial assets, taxes complicate the picture further. Withdrawals from traditional IRAs, Roth IRAs, and taxable brokerage accounts can carry very different tax consequences, and a thoughtfully coordinated withdrawal strategy may help manage taxes while also addressing investment risk.
Five Questions to Ask Before Retirement
If you're approaching retirement, I'd sit down and ask:
How would our retirement plan perform if markets declined 20% during our first year?
How much of our planned spending must come from investments, versus how much is covered by dependable income?
Do we maintain enough liquidity to avoid unnecessary investment sales during unfavorable markets?
How much flexibility do we have to temporarily adjust spending?
Have we evaluated our plan under different sequences of investment returns, not just different average returns?
These questions can reveal risks that aren't obvious from a traditional investment performance report. They also help distinguish between a portfolio built to accumulate wealth and one built to support retirement spending.
The Bottom Line
Most investors understand that market returns are unpredictable. Fewer recognize that the timing of those returns can matter enormously during retirement.
Two investors can experience identical investment performance and still end up with dramatically different financial outcomes, simply because of when the gains and losses occur relative to their withdrawals. That's why a retirement plan shouldn't rely exclusively on assumptions about average annual returns. It should also account for liquidity, spending flexibility, dependable income, investment allocation, and the potential consequences of unfavorable markets early in retirement.
The goal isn't eliminating market volatility. That's neither realistic nor necessary. The goal is building a retirement-income strategy that gives you the flexibility to live through market volatility without letting temporary market conditions dictate your long-term financial future.
Because successful retirement planning was never about predicting which years will be good or bad for investors. It's about making sure your financial life doesn't depend on getting that prediction right.
If you'd like to see how your own plan would hold up under a different sequence of returns, that's a conversation I'd welcome having with you.
Jeffrey A West Managing Partner, Financial Advisor Freedom Financial Wealth Management www.ffwm.net 717-920-0770 4 Lemoyne Dr, Suite 103 Lemoyne, PA 17043
To play the game, you've got to know the rules.
This material is provided for educational purposes only and does not constitute individualized investment, tax, or financial advice. Investing involves risk, including the possible loss of principal. Diversification, asset allocation, and cash reserves do not guarantee investment results or prevent losses. Retirement withdrawal strategies should be evaluated in light of your individual financial circumstances, objectives, and risk tolerance.