The Hidden Retirement Risk Behind “Good” Returns
A strong average investment return does not guarantee a secure retirement. Once you begin withdrawing money, the order in which gains and losses occur can dramatically affect how long your savings last. A market decline early in retirement can be especially damaging because you may be selling investments while their values are down.
This problem is called sequence-of-returns risk. It does not mean investing is a mistake or that retirement planning is hopeless. It simply means that retirees need more than an expected average return—they need a flexible plan for handling unpredictable markets.
Why Average Returns Do Not Tell the Whole Story
Imagine an investment earns the following returns over five years:
- Year 1: Loss of 20%
- Year 2: Loss of 10%
- Year 3: Gain of 10%
- Year 4: Gain of 20%
- Year 5: Gain of 30%
The simple average return is 6% per year. Now reverse the order so the gains happen first and the losses happen last. The average is still 6%.
If no money is added or removed, both sequences produce the same ending value. Multiplication works the same regardless of order. But retirement changes the calculation because you are regularly withdrawing money for groceries, housing, travel, medical care, and other expenses.
When losses happen early, withdrawals remove money from an already shrinking account. Less money remains invested when the eventual recovery arrives. As Charles Schwab’s explanation of sequence-of-returns risk notes, the timing of poor returns can meaningfully affect how long retirement savings last.
What Is Sequence-of-Returns Risk?
This risk is most dangerous near the transition into retirement. While you are working and regularly buying investments, falling prices can allow your contributions to purchase more shares. Once you retire and begin selling shares, the same decline can work against you.
Understanding what happens to investments during a market crash can make this difference easier to appreciate.
Two Retirees, the Same Returns and Different Results
Consider two hypothetical retirees who each begin with $500,000. Both withdraw $25,000 at the start of every year, and both experience the same five annual returns. The only difference is their order.
| Year | Retiree A: Losses First | Retiree B: Gains First | |---|---:|---:| | 1 | -20% | +30% | | 2 | -10% | +20% | | 3 | +10% | +10% | | 4 | +20% | -10% | | 5 | +30% | -20% | | Approximate ending balance | $433,862 | $505,312 |
Both retirees received the same returns and withdrew the same total amount. Yet Retiree B finishes with approximately $71,450 more.
Without withdrawals, both sequences would have turned $500,000 into approximately $617,760. The gap appears because the withdrawals interact with the changing account balance.
This simplified example ignores taxes, fees, inflation, and investment income, but it demonstrates the central problem: when you are withdrawing money, timing matters even if you never attempt to time the market.
Why Early Losses Are So Difficult to Overcome
Suppose your $500,000 portfolio falls by 20%, leaving $400,000 before accounting for withdrawals. If you then need $25,000 for living expenses, your balance falls to $375,000.
Recovering is now harder for two reasons:
- A percentage loss requires a larger percentage gain to reverse. A 20% decline requires a 25% gain to return to the starting value.
- You have fewer dollars and shares participating in the recovery. Investments sold to pay expenses cannot grow when markets rebound.
This is why “the market eventually recovered” may not be enough for a retiree. Recovery is helpful, but its benefit depends on how much of the portfolio remains invested when it arrives.
The goal is not to predict the next crash. No one can do that consistently. The goal is to build a retirement strategy that can survive one.
Six Ways to Reduce Sequence-of-Returns Risk
1. Keep a Short-Term Spending Reserve
Consider holding money for near-term expenses in cash or relatively stable, liquid investments. During a major stock market decline, this reserve may reduce the need to sell stocks immediately.
The appropriate amount varies by household. Holding too little may leave you vulnerable, while holding too much can limit long-term growth and expose more of your savings to inflation.
2. Build a Diversified Portfolio
A retirement portfolio does not have to be entirely invested in stocks or entirely held in cash. Stocks can provide long-term growth, while high-quality bonds and cash can add stability and help fund nearer-term spending.
A thoughtful mix begins with understanding what a well-diversified portfolio really looks like. Diversification cannot prevent losses, but it can reduce your dependence on one investment or market segment.
3. Start With a Sustainable Withdrawal Rate
The more you withdraw, the less room your portfolio has to recover from weak markets. A commonly discussed starting point is withdrawing around 4% to 5% in the first year and adjusting over time, but this is a planning estimate—not a promise.
Your retirement length, investment mix, expenses, taxes, inflation, and flexibility all matter. Fidelity describes 4% to 5% as a general starting estimate while emphasizing that an appropriate rate depends on individual circumstances.
4. Make Spending Flexible
Retirement spending does not have to increase automatically every year regardless of market conditions. You might postpone a large vacation, reduce optional purchases, or temporarily skip an inflation increase after a poor market year.
Even a modest reduction can help because it allows more money to remain invested during a recovery.
5. Review and Rebalance Your Investments
Your investment mix can drift as markets rise and fall. If stocks perform exceptionally well, they may eventually represent more of your portfolio than intended, leaving you exposed to a larger decline.
Periodic rebalancing returns your investments to their planned targets. Beginners can learn the process through this guide to asset allocation and why it matters.
6. Strengthen Income Outside Your Portfolio
Social Security, pensions, annuities, rental income, or part-time work may reduce the amount you must withdraw from investments. Guaranteed-income products can be complicated and may involve fees, restrictions, and insurer risk, so they should be evaluated carefully.
The broader principle is simple: the more essential expenses covered by dependable income, the less pressure placed on your portfolio during a downturn.
Create a Plan Before Markets Become Emotional
Sequence-of-returns risk becomes more difficult when retirement decisions are made during a market panic. Falling account balances can create fear, and fear can lead to rushed selling, extreme portfolio changes, or unnecessary lifestyle sacrifices.
Before retirement, write down:
- Your essential monthly expenses
- Your flexible expenses
- Your expected income sources
- Your target withdrawal amount
- Which assets you will use during a downturn
- How much spending you are willing to reduce
- When you will review and rebalance the portfolio
Vanguard’s guidance on setting up retirement withdrawals also emphasizes coordinating income sources and maintaining an appropriate cash portion for near-term needs.
A written plan cannot control the market, but it can prevent every market movement from controlling you.
Retirement Success Requires Resilience, Not Perfect Predictions
You do not need to know which year the next downturn will occur. You need a retirement plan strong enough to handle the possibility that it arrives at an inconvenient time.
That means combining reasonable withdrawals, diversified investments, short-term reserves, dependable income, and flexible spending. None of these tools eliminates risk, but together they can make your retirement more resilient.
Average returns are useful for estimating the future, but they are not the whole story. A successful retirement plan asks a better question: If the market performs badly at the worst possible time, what will I do next?
When you can answer that question calmly and confidently, you are no longer relying on luck alone.