Sequence of returns risk refers to the possibility that poor investment returns early in retirement can have a greater impact on a portfolio than the same poor returns occurring later.

 

The reason is relatively simple. Once retirees begin withdrawing money from their investments, market declines can become more damaging because they may be selling assets at depressed values to fund living expenses. Those withdrawals leave fewer assets invested to participate in a potential market recovery.

 

For Southern California Edison employees, this risk can be especially important when transitioning from accumulating retirement assets to using those assets to help fund retirement. Pension income, Social Security, 401(k) savings, IRAs, and other investments may all play a role in creating retirement income.

 

Sequence of returns risk does not mean retirees should avoid investing in the market. Instead, it highlights the importance of coordinating investment strategy, retirement income, liquidity, and withdrawals before and during retirement.

 

Why the Order of Investment Returns Matters

 

During your working years, market volatility can be uncomfortable, but time and continued contributions may provide an opportunity to recover from downturns.

 

Retirement changes the equation.

 

Once you begin withdrawing money from your portfolio, the order in which investment returns occur can become increasingly important. Two retirees could experience similar average investment returns over a long period and still have very different financial outcomes depending on when strong and weak markets occur.

 

Imagine two retirees who begin retirement with similar portfolios and withdraw approximately the same amount each year.

 

One experiences several strong investment years early in retirement followed by weaker markets later. The other encounters a significant market decline shortly after retiring and continues taking withdrawals during that downturn.

 

Even if their average long-term investment returns eventually look similar, the second retiree may have considerably less money remaining because withdrawals occurred while portfolio values were already depressed.

 

That is sequence of returns risk.

 

Key Question

If markets declined substantially during your first few years of retirement, would your income plan require you to continue selling investments to fund your lifestyle?

 

Why Sequence Risk Is Different From Normal Market Risk

 

Market risk is the possibility that investments may rise or fall in value.

 

Sequence of returns risk goes one step further. It considers the interaction between market performance and portfolio withdrawals.

 

For someone who is still working and contributing to retirement accounts, a market decline may provide an opportunity to purchase investments at lower prices.

 

For someone who has retired and is withdrawing money, the same decline can create a very different experience.

 

Selling investments after a decline may permanently remove shares from the portfolio. If markets subsequently recover, those shares are no longer invested and therefore cannot participate in the recovery.

 

This is why the years immediately before and after retirement are sometimes considered particularly important from a retirement income planning perspective.

 

A Simple Example of Sequence of Returns Risk

 

Consider two hypothetical retirees who each begin retirement with the same amount of money and take the same annual withdrawals.

 

Both portfolios experience the same series of positive and negative annual returns over time. The only difference is that the order of those returns is reversed.

 

The first retiree experiences stronger returns early and weaker returns later.

 

The second experiences the market declines first and stronger returns later.

 

If neither retiree were withdrawing money, the ending results could be similar because the average returns are the same.

 

Once withdrawals are introduced, however, the results may be significantly different.

 

The retiree who experiences losses early may be forced to withdraw money from a declining portfolio, leaving a smaller asset base available for future growth. The strong returns that eventually follow are therefore being earned on a smaller portfolio.

 

This illustrates an important retirement planning principle: average return alone does not necessarily tell you whether a retirement income strategy will be sustainable.

 

Why This Matters for SCE Employees

 

Southern California Edison employees may enter retirement with several sources of income.

 

Depending on individual circumstances, these could include:

 

• SCE pension benefits
• Social Security
• 401(k) assets
• Traditional and Roth IRAs
• Taxable investment accounts
• Cash reserves
• Other retirement or investment assets

 

The amount of predictable income available from pension and Social Security benefits can influence how dependent a retiree is on investment withdrawals.

 

For example, if pension and Social Security income cover a significant portion of essential living expenses, there may be less pressure to withdraw from investment accounts during a market decline.

 

Conversely, someone who depends more heavily on their portfolio for monthly income may be more exposed to sequence risk.

 

This is one reason retirement income planning should generally involve more than simply choosing investments. It should also consider where retirement income will come from and how withdrawals may change when markets are unfavorable.

 

Key Question

How much of your retirement lifestyle will depend on regular withdrawals from investments?

 

The Years Around Retirement Can Be Especially Important

 

Sequence of returns risk is generally most significant during the transition into retirement and the early years of portfolio withdrawals.

 

A severe decline later in retirement can certainly affect a portfolio, but a large decline shortly after retirement may be more difficult because there has been less time for the portfolio to grow and withdrawals have just begun.

 

This period is sometimes referred to as the retirement risk zone.

 

For employees preparing to retire, reviewing investment risk several years before retirement may help determine whether the portfolio still reflects the investor's changing objectives.

 

A portfolio designed primarily to maximize long-term accumulation may not necessarily be structured appropriately for someone who will soon begin taking regular distributions.

 

This does not mean becoming overly conservative. A retirement portfolio may still need long-term growth to help address inflation and longevity. The appropriate balance depends on the retiree's financial circumstances, income needs, time horizon, and tolerance for risk.

 

How Can Retirees Manage Sequence of Returns Risk?

 

There is no single strategy that eliminates sequence risk. Instead, retirees may consider several planning approaches designed to reduce dependence on selling investments during difficult markets.

 

Maintain Appropriate Liquidity

Keeping a portion of near-term spending needs in cash or other relatively liquid assets may provide flexibility during periods of market volatility.

Rather than selling investments immediately after a significant decline, retirees may be able to draw from available reserves while giving longer-term investments additional time to recover.

The appropriate amount of liquidity varies depending on the individual's income sources, spending needs, investment strategy, and overall financial plan.

 

Coordinate Pension and Social Security Income

Predictable income sources can play an important role in retirement.

 

For SCE employees, pension benefits and Social Security may cover part of the household's regular expenses. Understanding how much of the retirement budget is already supported by these resources can help determine how much must come from investment accounts.

 

The greater the dependence on portfolio withdrawals, the more important managing sequence risk may become.

 

Build Flexibility Into Retirement Spending

Not every retirement expense is equally important.

 

Housing, food, healthcare, and other essential expenses may be difficult to reduce. Travel, entertainment, major purchases, and gifts may provide greater flexibility.

 

If markets experience a significant decline, temporarily reducing discretionary withdrawals may help limit the amount that needs to be sold from a portfolio at depressed values.

 

A retirement plan that assumes spending will increase every year regardless of market conditions may be less adaptable than one that allows for reasonable adjustments.

 

Review Portfolio Risk Before Retirement

The investment allocation that helped build retirement assets may not necessarily be the allocation that best supports retirement withdrawals.

 

As retirement approaches, it may be appropriate to evaluate how much market volatility the portfolio could experience and whether that level of risk aligns with expected withdrawal needs.

 

Being too aggressive can expose retirees to substantial losses at an unfortunate time. Being too conservative can create other risks, including reduced long-term growth and greater exposure to inflation.

 

The objective is generally to find an appropriate balance rather than attempting to eliminate market risk altogether.

 

Sequence Risk and Inflation

Sequence of returns risk does not exist in isolation.

 

Inflation may increase the amount retirees need to withdraw over time. If rising expenses coincide with weak investment markets, the combination can place additional pressure on a retirement portfolio.

 

For example, a retiree may need larger withdrawals to maintain the same lifestyle precisely when investment values are declining.

 

This is one reason retirement planning should consider multiple risks together rather than evaluating each separately.

 

Market volatility, inflation, longevity, taxes, healthcare expenses, and spending all interact with one another.

 

Sequence Risk and Longevity

A longer retirement increases the importance of preserving enough assets to support future spending.

 

Someone retiring in their early or mid-60s may need retirement resources to last for several decades. A large portfolio decline early in that period can potentially affect the amount of money available much later in life.

 

This creates an important balance.

 

Retirees may need enough investment growth to help their assets keep pace with inflation and potentially support a long retirement, while also managing the risk associated with substantial market declines.

 

That balance is one of the central challenges of retirement income planning.

 

Common Mistakes to Avoid

 

Assuming Average Returns Tell the Whole Story

A retirement projection based only on an average investment return may not fully reflect what could happen if poor returns occur early.

 

Taking the Same Investment Risk After Retirement

Retirement changes how a portfolio is used. Once withdrawals begin, it may be appropriate to reconsider how investment risk aligns with income needs.

 

Maintaining Too Little Liquidity

Without sufficient readily available resources, retirees may be forced to sell investments during unfavorable market conditions.

 

Reacting Emotionally to Market Declines

Moving entirely to cash after a significant decline may prevent a portfolio from participating fully in a subsequent recovery.

 

Ignoring Spending Flexibility

Retirement income does not always need to operate on autopilot. The ability to temporarily adjust discretionary spending may help reduce pressure on investment assets.

 

Looking at Investments Separately From Income Planning

Investment allocation and retirement income strategy should generally be coordinated. Pension income, Social Security, cash reserves, and portfolio withdrawals all influence how much market risk a retiree may be able to tolerate.

 

Key Takeaways

Sequence of returns risk is the possibility that poor investment performance early in retirement can have an outsized impact when portfolio withdrawals are occurring at the same time.

 

For Southern California Edison employees, pension benefits and Social Security may provide predictable income that can reduce dependence on investment withdrawals, but the importance of sequence risk will vary based on each retiree's financial circumstances.

 

Managing this risk may involve maintaining appropriate liquidity, coordinating retirement income sources, reviewing portfolio allocation, and creating flexibility around withdrawals and discretionary spending.

 

Most importantly, retirement planning should not rely solely on an assumed average investment return. The timing of returns can matter considerably once a portfolio becomes a source of retirement income.

 

Frequently Asked Questions

 

What is sequence of returns risk?

Sequence of returns risk is the possibility that poor investment returns early in retirement may have a greater impact on a portfolio because withdrawals are occurring at the same time.

 

Why does sequence risk matter more after retirement?

Before retirement, investors may have time to recover from market declines without withdrawing assets. After retirement, selling investments during a downturn can reduce the amount of money remaining to participate in a future recovery.

 

Can pension income reduce sequence of returns risk?

Predictable pension income may reduce the amount that needs to be withdrawn from investment accounts, which can potentially reduce exposure to sequence risk. The effect depends on the retiree's overall income and spending needs.

 

Should retirees move their investments to cash to avoid sequence risk?

Holding an appropriate amount of liquidity may provide flexibility, but moving an entire long-term portfolio to cash can introduce other risks, including inflation and reduced growth potential. Investment decisions should reflect individual circumstances and objectives.

 

When is sequence of returns risk greatest?

Sequence risk can be particularly important during the years immediately before and after retirement, when an individual transitions from accumulating assets to regularly withdrawing them.

 

Final Thoughts

 

The transition from saving for retirement to living from retirement assets changes the way investment risk should be viewed.

 

For Southern California Edison employees, understanding sequence of returns risk can help put market volatility into a broader retirement planning context. The concern is not simply whether markets will decline. Market declines are a normal part of investing. The more important question is how your financial plan is designed to respond when a decline occurs.

 

At Guardian Financial Partners, we believe retirement planning should bring together investments, pension benefits, Social Security, liquidity, taxes, and spending into a coordinated strategy. Preparing for periods when markets do not cooperate can help retirees make more informed decisions while working to preserve their assets and protect their lifestyle.

 

About the Author

 

Casey S. Bartels, CFP® is a Founding Partner of Guardian Financial Partners. Since 2007, Casey and his partners have worked with Southern California Edison employees and executives, helping them navigate retirement planning, pension decisions, and other important financial considerations.

 

 

Educating Edison is our educational series designed to help Southern California Edison employees better navigate their financial lives.

 

 

Guardian Financial Partners is a Registered Investment Adviser. Guardian Financial Partners is not affiliated with, endorsed by, or sponsored by Southern California Edison.