3 Signs You're Exposed to Sequence-of-Returns Risk

If your retirement plan lacks tax diversification, a cash buffer, and an awareness of the "retirement red zone," you may be highly vulnerable to sequence-of-returns risk.

Key Takeaways

• A market downturn early in retirement is far more damaging than the same downturn a decade later, because withdrawals lock in losses permanently.

• Morningstar identifies the five years before and after retirement as the "retirement red zone," the highest-risk window for sequence-of-returns damage.

• A $5,000 living expense can require withdrawing $6,500 or more from a traditional 401(k) or IRA once taxes are factored in, compounding portfolio losses during a downturn.

What Is Sequence-of-Returns Risk?

Sequence-of-returns risk is the danger that the timing of investment losses, not just their size, will permanently reduce a retirement portfolio's longevity. When a retiree withdraws money to cover living expenses during a market decline, those withdrawn dollars are never reinvested and therefore cannot participate in the eventual recovery. Two retirees with identical average annual returns over a 20-year retirement can end up with dramatically different outcomes depending solely on whether losses occurred early or late in that period.

Sign 1: Almost All of Your Savings Are in Traditional 401(k)s or IRAs

Retirement accounts funded with pre-tax dollars create a hidden tax drag at withdrawal. Because every dollar distributed is taxable, covering a $5,000 monthly expense may require pulling $6,500 or more from the portfolio. During a market decline, this means selling more shares at depressed prices than the actual living expense requires. Retirees without Roth accounts, taxable brokerage accounts, or other after-tax savings have no way to selectively draw from lower-cost sources when markets fall.

Sign 2: You Are Within Five Years of Retiring or Recently Retired

"The five years before and after retirement represent the window when the timing of a downturn can do the most lasting damage." -- Warren Burger, Financial Advisor

Morningstar refers to this period as the "retirement red zone." A portfolio hit by a major decline during this window has less time to recover before distributions begin or accelerate, and the math of compounding works in reverse: losses early in the distribution phase shrink the base from which all future growth is calculated.

Sign 3: You Have No Cash or Bond Buffer Outside Your Stock Portfolio

Without a dedicated cash reserve or a short-term bond allocation sitting outside the equity portfolio, every monthly withdrawal is sourced directly from whatever the market is doing on that day. A retiree with a one-to-three-year cash buffer can cover living expenses without selling equities during a downturn, giving the stock portion time to recover before it must be liquidated.

Steps to Reduce Your Exposure

1. Audit your account mix: Identify how much of your retirement savings is in pre-tax accounts versus Roth or after-tax accounts. A tax-diversified mix gives you flexibility to choose which bucket to draw from depending on market conditions and your tax situation.

2. Establish a cash or bond buffer: Work with an advisor to determine how many months or years of living expenses should be held in stable, low-volatility assets outside your equity allocation.

3. Model your retirement red zone: If you are within five years of your target retirement date, stress-test your plan against a significant early drawdown scenario to see how long your portfolio would last under adverse conditions.

4. Review your withdrawal strategy: A dynamic withdrawal strategy that reduces distributions during down markets and increases them during strong markets can significantly reduce sequence-of-returns exposure over time.

The market will decline again. The question is whether your retirement plan accounts for when that decline happens, not just whether it happens.