The Sequence of Return Risk: A Retirement Red Zone

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• Cash is king again as money-market funds hit record highs.
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So, you’ve spent decades saving for retirement. You’ve maxed out your 401(k), diversified your portfolio, and dutifully ignored the urge to panic-sell during every market dip (if you need a reminder why this is smart, read Just Because the Stock Market Panics Doesn’t Mean Investors Should, Too). After doing everything right, you may be tempted to think that the last stretch leading up to your retirement date is little more than a victory lap.

Not so fast. The final years leading up to your retirement date and the years that immediately follow pose their own special set of dangers, even for the most diligent savers.

One such danger is a prolonged market downturn in the years just before you retire. This can do serious, lasting damage to your savings, even if the market fully recovers afterward.

Welcome to the sequence of return risk— a retirement red zone that stretches across about the five years before and the five years after you stop working. Football fans know the red zone as the stretch of field where games are won or lost. The retirement version works the same way– except you only get one drive.

This is a window during which a prolonged market downturn can do disproportionate damage to your savings. The usual “just wait it out” advice doesn’t quite apply the way it did during your working years, when you had wages coming in and time to let the market recover.

Why should you be concerned about the sequence of return risk?

In simple terms, one becomes the victim of the sequence of return risk if your investment portfolio takes a serious dive right when you retire and you’re forced to sell your investment assets at a loss just to cover living expenses.

When the value of the assets you sold eventually recovers– and they probably will– it won’t help you because, well, you’ll have already sold them. When the remainder of your smaller portfolio recovers and starts to produce great returns, those great returns will be on a much smaller pile of money. You may never fully make up the ground you lost.

When it comes to retirement income, the timing of market returns matters. During your working years, market declines can actually work in your favor if you’re continuing to invest because you’re buying shares at lower prices. But once retirement begins and money starts flowing out of your portfolio instead of into it, the timing of market returns becomes much more important.

Consider two retirees who earn the exact same average return over their retirement. One experiences a major downturn during the first few years of retirement, while the other encounters that same downturn much later. Despite earning the same average return, the first retiree may end up with significantly less money because withdrawals made during the early downturn permanently reduced the portfolio’s ability to recover. Same average return, very different retirements. In retirement math, the order of the returns matters as much as the returns themselves.

None of this is new information. But what’s particularly concerning now is that a lot of retirement money is currently sitting in this vulnerable window.

Roughly 10,000 baby boomers turn 65 each day. That’s a sold-out Madison Square Garden’s worth of new retirees every two days. That’s a large share of Americans who are entering retirement, just as market volatility, geopolitical uncertainty, and questions about the durability of AI-driven growth are rattling investors.

Extended losing streaks in the market are relatively rare. In the last 100 years, the S&P 500 has only posted negative returns for two or more consecutive years four times: during the Great Depression, around World War II, in the mid-1970s, and during the dot-com bust. But “rare” is cold comfort if your retirement happens to land in one of those windows.

What Can You Do About It?

The good news is that sequence of return risk is manageable, and it doesn’t require sophisticated investment strategies to do it. Financial advisers generally point to a few core strategies:

Diversify and rebalance

Don’t put all your eggs in one basket.

Spread your investments across asset classes that don’t move in lockstep. This reduces your dependence on any single market. A properly diversified portfolio helps ensure that weakness in one market segment doesn’t sink your entire retirement plan.

Alongside this is the need to stay disciplined with portfolio rebalancing, which involves taking steps to maintain the original asset mix and the original level of diversification in your investments.

Rebalancing is necessary when some investments grow faster than others and push your holdings out of alignment with your investment goals. It also forces you to buy low and sell high. The goal is to avoid locking in losses by selling assets after they have already declined in value.

For more on diversifying and rebalancing, read Investing Basics for Beginners Installment #3: Never Put All Your Eggs in One Basket.

Keep a cash reserve

If you have a cash reserve, you can draw on that for your living expenses, rather than being forced to sell investments at depressed prices.

There is also a psychological benefit to having cash on hand that can translate directly into better decision-making: A dedicated cash reserve makes it easier to stay disciplined during a downturn, rather than making emotionally driven investment decisions.

How much of a cash reserve should you aim to save for retirement?

Financial planners generally advise investors to hold enough cash to cover a retiree’s expected 12-month spending shortfall– the gap between guaranteed income sources such as Social Security or a pension and what the retiree expects to spend. Keep those funds in a money-market account or an interest-bearing bank account, where they can earn something while they wait.

Use a “bucket” approach

The “bucket” approach is a strategy used by many retirement planners. Under this approach, retirement assets are divided into short-, medium-, and long-term buckets.

The short-term bucket holds cash and highly liquid investments that can fund near-term spending needs. Charles Schwab advises keeping roughly two to four years’ worth of living expenses in short-term bonds, certificates of deposit, or other reasonably liquid accounts. This is because since the 1960s, the average peak-to-peak recovery time for a diversified index of stocks in bear markets was about 3.5 years.

Medium- and longer-term buckets contain progressively riskier investments designed to generate growth over time.

The goal here is to stagger out investments across different buckets. For example, you may look at using investment-grade bonds with staggered maturities. By creating a bond ladder, you can generate a steady income stream while ensuring that cash becomes available at progressive intervals as bonds mature.

Cut back on withdrawal rate during market downturns and rebounds

This one may seem like stating the obvious– cutting back on spending.

That may mean temporarily reducing discretionary expenses, delaying major purchases, or even foregoing annual inflation adjustments.

No one enjoys cutting back, but even modest spending reductions can significantly reduce the amount that must be withdrawn from a portfolio during a downturn.

Here’s a scenario by Charles Schwab. Picture two different investors, Lucy and Ethel, each with a $1 million portfolio, who experience a 15% decline in their first two years of retirement.

Let’s assume the following: the market rebounds in the third year, growing at 6% per year thereafter. Lucy and Ethel withdraw money from their investment accounts at different rates. Lucy withdraws 2% of her total assets each year. Ethel, in contrast, withdraws 4% of her total assets each year.

Lucy’s investment portfolio will recover to its starting value in about 11½ years of consecutive growth to recover their portfolio. Ethel’s will take about 28 years. The difference between 11.5 years and 28 years isn’t investment skill– it’s two percentage points of spending. Frugality, it turns out, is the one asset class that never has a down year.

Timing is NOT Everything

Our point here is that there is no way to predict when your investment portfolio will take a serious hit as a whole. The good news is that you don’t need to predict the next recession or market correction to prepare for it. What’s critical here is understanding how the timing of returns can affect a retirement portfolio and taking steps to mitigate losses if they occur during the retirement red zone.

You can’t control what the market does the year you retire any more than you can control the weather on your wedding day. But you can rent the tent. A cash reserve, a few buckets, and a flexible withdrawal rate are the tent– unglamorous, slightly costly, and the only thing standing between you and a very wet party.