Retirement Income
The First Five Years of Retirement Carry the Most Risk
A bad market early in retirement does more damage than the same bad market later. Understanding why changes how you plan.
What sequence-of-returns risk means
Sequence-of-returns risk is the danger that the order of investment returns — not just the average — can permanently impair a retirement portfolio. Two retirees with identical average returns over 30 years can end up with dramatically different outcomes depending on whether the bad years came early or late. The retiree who experiences a major market decline in the first five years of retirement, while withdrawing from the portfolio, is in a fundamentally different position than the retiree who experiences the same decline in year 25.
Why withdrawals make it worse
During the accumulation phase — when you are saving — a market decline is painful but recoverable. You continue contributing, and you buy more shares at lower prices. In retirement, the dynamic reverses. You are withdrawing from the portfolio, not adding to it. A 30% market decline in year two of retirement forces you to sell more shares to generate the same income. Those shares are gone and cannot participate in the recovery. The portfolio is permanently smaller than it would have been.
The math of a bad start
Consider two retirees, each starting with $1 million and withdrawing $50,000 per year. Retiree A experiences strong returns in the first decade and a major decline in year 15. Retiree B experiences the same major decline in year 3. Even if both portfolios have the same average annual return over 30 years, Retiree B is likely to run out of money significantly earlier. The sequence, not the average, is what determines the outcome.
Strategies that reduce the risk
Several approaches can reduce sequence-of-returns exposure. Maintaining a cash or short-term bond reserve — one to three years of living expenses — allows you to avoid selling equities during a downturn. A flexible withdrawal strategy that reduces spending modestly in down years can extend portfolio longevity significantly. Guaranteed income sources — Social Security, pensions, annuities — reduce the amount that must be withdrawn from the portfolio in any given year, which reduces the damage a bad sequence can do.
The transition zone
The five years before retirement and the five years after are sometimes called the 'retirement red zone' — the period when sequence-of-returns risk is highest and the consequences of a major loss are most severe. Portfolio construction during this window typically involves reducing equity exposure, building income reserves, and stress-testing the plan against adverse scenarios. This is not the time to be fully invested in equities with no buffer.
The first years of retirement are the most financially vulnerable. Planning for that vulnerability — before it arrives — is one of the most valuable things a retirement plan can do.
If you are within five years of retirement and have not stress-tested your plan against an early market decline, that is worth doing.
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