When planning for the future, pre-retirees may forecast a sustainable withdrawal strategy based on decades of growth and a recent history of higher-than-average stock market returns. However, returns alone don’t determine if a retirement plan is successful — it’s the timing of those returns. For example, retirement outcomes could look vastly different if you have gains of +10% versus losses of -10% in the first few years as withdrawals begin. Negative returns in the early years of retirement are known as sequence of returns risk, which is an essential concept for those approaching retirement.
While the markets are unpredictable, there are strategies to help mitigate against downturns in retirement that could otherwise be difficult to recover from.
What is Sequence of Returns Risk?
Sequence of returns risk (SORR) refers to market volatility and the potential for negative returns in the early years once a retiree begins withdrawals. SORR can have lasting impacts on your portfolio, affecting how long your money lasts in retirement, making it a critical area to account for in retirement planning.
This concept becomes more impactful as you enter retirement, when the decumulation, or “spending,” phase begins. For decades, during the accumulation or saving phase of your career, market volatility likely had a low long-term impact. Why? Because you had years of compounding combined with regular contributions and market corrections, allowing your portfolio time to recover, which may not be possible in retirement.
Example: Let’s look at two investors. While they experience the same long-term returns over five years, Investor A has gains early on and Investor B has losses early on:
Starting Balance: $1 million
Annual Withdrawals: $50,000
| Year | Investor A Returns: Gains Early | Portfolio Balance After Withdrawals | Investor B Returns: Losses Early | Portfolio Balance After Withdrawals |
| 1 | +10% | $1,050,000 | -10% | $850,000 |
| 2 | +8% | $1,084,000 | -8% | $732,000 |
| 3 | +6% | $1,099,040 | +10% | $755,200 |
| 4 | -8% | $961,117 | +8% | $765,616 |
| 5 | -10% | $815,005 | +6% | $761,553 |
After five years, Investor A has over $50,000 more remaining than Investor B.
The “Retirement Red Zone”: Why the First 5 Years Are Critical
The critical window during which market downturns can detrimentally affect portfolios is the five years before and after retirement begins, referred to as the “retirement red zone.” This is likely when your balance is at its highest, which can mean big losses too.
A downturn early on essentially is compounding but in reverse: as retirees begin to withdraw, they’re reducing an already shrunken portfolio balance. Additionally, they may have to sell at a loss or sell more assets to generate the same income, permanently reducing their overall savings, which could continue to grow. This makes it mathematically more difficult to recover, even if markets gain strength later in retirement.
5 Strategic Ways to Mitigate Sequence Risk
Returns alone are not enough; a successful retirement involves accounting for how those returns and withdrawals interact over time. While no one can predict the exact sequence of returns, we specialize in guiding pre-retirees through retirement strategies that can help reduce the damage of a downturn early in retirement and provide peace of mind.
Liquidity Management: The Bucket Strategy
The bucket strategy is a common method that divides assets into different buckets based on time horizon and purpose.
- Short-term bucket: Investors may include stable assets such as cash and money markets to cover one to three years of spending needs. Relying on stable assets early on can help retirees avoid selling at a loss during a market dip.
- Mid-term bucket: This bucket may include income-generating assets, such as bonds, that can help replenish the short-term bucket as the market recovers.
- Long-term bucket: This bucket often focuses on growth-oriented, long-term assets, such as stocks, that can continue to grow and support spending later in retirement.
Dynamic Withdrawal Rates
Many pre-retirees have probably heard of the “4% Rule,” which calls for withdrawing a fixed percentage from their portfolio each year. However, a dynamic withdrawal rate that adjusts based on market performance may be a more realistic approach to mitigating SORR and extending a portfolio’s longevity. For example, adjustments may look like temporarily reducing withdrawals during a market downturn or predefining how much you can increase or decrease spending each year.
Cash Buffers & Diversified Income
Leveraging multiple income sources, such as Social Security, pensions, or rental property income, can also help provide flexibility as markets shift. For example, delaying your Social Security benefits, which are not correlated with market volatility, could increase your long-term guaranteed income later in retirement.
Dependable income from these types of assets can help retirees rely less on portfolio income and reduce or avoid withdrawals during a bear market.
Tax-Efficient Withdrawal Sequencing
In addition to returns, when and where you begin your withdrawals — or withdrawal sequencing — also matters. Most retirees have a mix of accounts with different tax treatments that can be strategically aligned. While retirees often take a dynamic withdrawal sequence based on markets and other factors, here’s a common tax-efficient withdrawal sequence:
- First: Taxable. Taxable brokerage accounts hold stocks and mutual funds that are funded with after-tax dollars. Investors are subject to short- and long-term capital gains taxes and can use tax-loss harvesting to offset some gains. Withdrawing from these accounts first, especially on long-held assets with a more favorable tax rate, can allow tax-deferred and tax-free accounts to continue growing.
- Second: Tax-deferred. Examples include traditional IRAs and 401(k)s, where contributions are tax-deductible, and withdrawals are taxed as ordinary income. Allowing these funds to continue compounding can help provide more income and flexibility later in retirement.
- Third: Tax-free. Ideally, retirees allow these funds to grow as long as possible. Tax-free withdrawals from accounts, such as a Roth IRA, don’t increase ordinary income, which can help retirees manage costs like Medicare premiums and Social Security taxes.
The “Safety First” Allocation
Pre-retirees often hold significant equity, such as stock, in their portfolios to support long-term growth during their accumulation years. However, it may be worth rebalancing and reducing equity exposure before retirement. This approach can help lessen the impact on a large portion of your assets if you enter retirement during market volatility. An advisor can recommend ways to structure your portfolio with lower-risk assets to help cover your short-term income needs and smooth market volatility.
Why a Holistic Plan Beats a “Portfolio-Only” Approach
How you construct your portfolio leading up to retirement matters, but guarding against SORR is much more about proactive planning than about markets and investments. There are many factors, including spending, taxes, and strategically aligning resources, that contribute to sustaining the lifestyle you want, shifting the conversation from portfolio-only to lifestyle engineering. Decisions like allocation adjustments, tax-efficient withdrawals, cash reserves, and Social Security timing all help reduce pressure on your portfolio during the retirement red zone.
At Blankinship & Foster, our investing philosophy is simple: We do not believe clients have to take unnecessary risks to have a comfortable retirement. “Enough not more” means finding the right balance of growth and stability, or taking just enough risk to achieve your long-term goals. This approach can often help pre-retirees reduce their sequence of returns risk in the first place.
How Blankinship & Foster Helps You Navigate the Red Zone
Supporting our holistic approach, we integrate multiple factors, such as investments, cash flow, taxes, and long-term goals, when guiding clients through retirement planning. Tools such as Monte Carlo simulations that are included in our wealth management services provide valuable insights, enabling us to stress-test hypothetical scenarios based on market returns, life expectancy, spending, inflation, and other factors. This modeling allows pre-retirees to see how their plan may perform under different conditions and where adjustments may be necessary.
Retirement Planning with Blankinship & Foster: Taking Control of the Clock
SORR is another reminder that retirement planning requires thoughtful, integrated, and strategic planning that extends beyond a returns focus. While we can’t control market changes, we help pre-retirees structure their portfolios so they can respond more effectively to them. Managing liquidity, leveraging diversified income sources, and developing tax-efficient, dynamic withdrawal strategies can help retirees be more resilient and avoid selling assets during a downturn.
This integrated approach can help pre-retirees understand what’s enough so they can enter retirement balancing growth, risk, and income to support their spending and long-term goals.
We invite you to meet our team if you’d like guidance on comprehensive retirement planning that considers taxes, investments, and cash flow to help inform your decision-making before volatility hits. For more information please contact us or visit our dedicated page for pre-retiree readiness and planning.