Most people understand that investing involves market risk. What fewer people understand is that when market losses happen can be just as important as how large those losses are.

This becomes especially important around retirement.

It’s called sequence of returns risk, and it can have a major impact on how long retirement savings last.

What Is Sequence of Returns Risk?

During your working years, you’re typically adding money to retirement accounts.

When markets decline, you may have time to recover before needing those assets.

Retirement changes the equation.

Now you’re withdrawing money to pay expenses.

If significant market declines occur during the first several years of retirement while you’re simultaneously making withdrawals, you may be forced to sell investments while their values are down.

Those assets are no longer available to participate fully in a later market recovery.

A Simple Example

Imagine two retirees starting with identical portfolios.

Over 20 years, both experience the same average investment return.

But Retiree A experiences several strong years at the beginning and poor years later.

Retiree B experiences the poor years immediately after retirement.

Even though their long-term average returns may be similar, Retiree B could potentially run out of money much sooner because withdrawals occurred while the portfolio was depressed.

That’s sequence of returns risk.

Why the First Years of Retirement Matter

The years immediately before and after retirement are sometimes called the retirement red zone.

You’ve accumulated assets for decades, but now you have less time to recover from a major market decline.

At the same time, you may be beginning regular withdrawals.

A 25-year-old experiencing a market correction has decades before retirement.

A 65-year-old depending on that portfolio for monthly income has a very different problem.

How Can You Reduce Sequence Risk?

There isn’t one universal solution, but retirement strategies can use several approaches.

Some retirees maintain cash reserves so they aren’t forced to sell investments during market downturns.

Others diversify their income among sources such as:

• Social Security
• Pensions
• Cash reserves
• Bonds
• Retirement accounts
• Investments
• Annuity income

Certain annuities can also be used to establish a predictable stream of retirement income, depending on the contract.

The idea isn’t necessarily to eliminate market investments.

Instead, it may be beneficial to avoid requiring every dollar of retirement income to depend on what the market happens to be doing that year.

Retirement Planning Is Different From Accumulation

Building wealth and distributing wealth are two different financial challenges.

During accumulation, the focus is often:

“How much can my money grow?”

During retirement, another question becomes equally important:

“How much income can I safely take without running out?”

That’s why a retirement income plan should consider more than average historical returns.

It should consider market volatility, inflation, longevity, taxes, healthcare costs, withdrawal rates, and sequence of returns risk.

Protecting your nest egg isn’t necessarily about avoiding risk completely. It’s about identifying the risks that could have the greatest impact and creating a retirement strategy designed to manage them.