Why the timing of returns matters in retirement

Imagine two retirees each start with a portfolio worth $1 million and both earn exactly the same average investment return throughout retirement. Despite this, one finishes with significantly less wealth than the other. How is that possible? The answer is sequencing risk.

Sequencing risk refers to the risk that investment returns occur in an unfavourable order. While long-term average returns are important, the timing of those returns can have a significant impact on retirement outcomes when withdrawals are being made from a portfolio.

The risk is greatest in the years immediately before and after retirement when portfolio balances are typically at their highest and withdrawals are beginning. Market declines during this period can have a disproportionate impact on long-term retirement outcomes.

When losses and withdrawals compound each other

The key challenge is the interaction between withdrawals and market declines. When negative returns occur early in retirement, withdrawals may still need to be made to fund living expenses. This reduces the amount of capital remaining in the portfolio and means less money is available to participate when markets eventually recover. As a result, two portfolios with identical long-term returns can produce very different outcomes depending on the order in which those returns occur.

Importantly, the issue is not whether markets recover over time. History suggests they generally do. Rather, the challenge is whether a retiree can continue funding their spending needs while waiting for that recovery.

Order of returns critical when income is being drawn from a portfolio

Sequencing risk is largely irrelevant in the absence of withdrawals. As shown in the table below, two portfolios experiencing the same returns in a different order ultimately finish with the same end value. While portfolio balances differ throughout the period, both portfolios end at approximately $1.16 million because no money has been withdrawn.

Sequencing risk is largely irrelevant if no withdrawals are being made

The situation changes once withdrawals begin. When capital is being drawn from a portfolio, poor returns early in retirement can have a lasting impact on retirement outcomes.

The below chart extends the previous example by incorporating annual withdrawals of $70,000, increasing by 3% each year to account for inflation. Although the underlying investment returns are identical in both scenarios, the order in which those returns occur now matters significantly. The portfolio that experiences losses early in retirement finishes with approximately $528,000, compared with $787,000 for the portfolio where those losses occur later.

End portfolio value under a fixed withdrawal strategy

The difference arises because withdrawals made during periods of market weakness permanently reduce the capital available to participate in subsequent market recoveries.

This highlights an important trade-off in retirement planning. While a fixed dollar withdrawal strategy provides a stable income stream, it can place additional strain on the portfolio during periods of poor returns early in retirement.

By contrast, withdrawing a fixed percentage of the portfolio helps align income with portfolio performance and reduces the risk of depleting capital. However, as can be seen below, this strategy results in more variable income over time as withdrawals fluctuate with portfolio values.

Fixed percentage withdrawals preserve capital but create income variability

The severity of sequencing risk also depends on the nature of the market decline. A short and sharp downturn, such as the one experienced during the Covid pandemic, may have relatively limited long-term consequences if markets recover quickly. However, prolonged drawdowns, such as those experienced during the Global Financial Crisis, can be far more damaging because you may need to fund several years of spending while waiting for markets to recover.

Strategies to help reduce sequencing risk

There are several practical ways to manage sequencing risk in retirement when withdrawals are being made.

Diversification can play an important role in reducing both the depth and duration of drawdowns, which in turn can help mitigate sequencing risk. While it does not eliminate market declines, a balanced portfolio (typically around 60% growth assets and 40% income assets) has historically experienced smaller drawdowns than portfolios solely concentrated in equities, making them less vulnerable to large losses during weaker market environments.

Holding sufficient liquidity is another important strategy. Maintaining two to three years of expected withdrawals in cash or other low-risk assets can reduce the need to sell growth assets during periods of market stress, allowing time for portfolios to recover.

The structure of withdrawals also plays a critical role. Larger withdrawals early in retirement increase sequencing risk because more capital is withdrawn before the portfolio has time to recover from market declines. Where possible, maintaining flexibility, such as drawing a variable percentage of the portfolio or reducing withdrawals following weaker market performance, can improve long-term sustainability.

Income diversification also plays a meaningful role. Government superannuation, income from bonds, and reliable dividend streams can reduce the need to sell growth assets during periods of market stress. Over time, this can help smooth income and reduce the long‑term impact of market downturns.

Finally, it is important not to become overly defensive. While moving entirely into cash may reduce short-term volatility, it increases the risk that your portfolio will not keep pace with inflation over time. Retirement can last 20 to 30 years or more, meaning portfolios still need exposure to growth assets to preserve purchasing power and support future income needs.

The challenge is finding the right balance between protecting capital and generating sufficient long-term growth. Every person’s circumstances are different, and determining the most appropriate asset allocation at a particular stage of life is something our advisers can help you with.

While sequencing risk cannot be eliminated, it can be managed. By maintaining a diversified portfolio, holding adequate liquidity, carefully managing withdrawals and retaining an appropriate allocation to growth assets, you can strengthen the resilience of your retirement portfolio and reduce the risk that poor market timing undermines your long-term financial security.

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