As retirement approaches, the financial strategies that served investors well during their accumulation years should undergo a fundamental shift. During our working lives, market volatility and downturns can actually benefit long-term investors through dollar-cost averaging. However, this same volatility becomes one of the greatest threats to financial security once the retirement phase begins.

This transition from accumulation to decumulation represents a pivotal change in investment approach that many soon-to-be retirees fail to properly address. Understanding the unique risks that emerge during this transition—particularly sequence of returns risk—can mean the difference between a comfortable retirement and one marked by financial stress and diminished lifestyle.

The Critical Pre-Retirement Window

The five to ten years immediately preceding retirement represent what financial experts call the "retirement risk zone"—a period when portfolios are typically at their largest and most vulnerable to market downturns. A significant market correction during this window can have devastating and permanent effects on retirement security.

Consider that a 20% market decline when your portfolio is at its peak can erase years of contributions and growth. For younger investors with decades remaining before retirement, such a decline represents a buying opportunity. But for those on the cusp of retirement, there may simply not be enough time to recover before withdrawals begin.

Understanding Sequence of Returns Risk

Sequence of returns risk is perhaps the most significant threat to retirement portfolios, yet it remains poorly understood by many investors. Put simply, it refers to the danger that the order in which investment returns occur can dramatically impact a portfolio's longevity, even when the average return remains identical.

This phenomenon functions as the mirror image of dollar cost averaging. During the accumulation phase, investors benefit from buying more securities, stocks in particular, when prices are low. But in retirement, the dynamic reverses—withdrawing funds during market downturns forces the liquidation of more shares to generate the same income, permanently reducing the portfolio's capacity to recover when markets eventually rebound.

A Tale of Two Retirements

Consider two retirees, both starting with identical $1 million portfolios, making the same $50,000 annual withdrawals, and experiencing the same average annual return of 7% over 25 years. The only difference is the sequence in which those returns occur:

This stark difference in outcomes illustrates why conventional wisdom about long-term average returns becomes dangerously misleading in retirement. Once withdrawals begin, the timing of returns matters tremendously.

The Math Behind the Risk

The mathematics of sequence risk reveals why early retirement returns have such outsized impact. When withdrawals occur during market declines, investors must sell more assets to generate the same income.

Even after markets subsequently recover, the impaired portfolio cannot fully participate in the recovery. This negative compounding effect is what makes sequence risk so destructive.

For example, withdrawing $50,000 from a declining portfolio might require selling 2-3% of total shares in a normal market, but 4-5% during a significant downturn. Those additional 1-2% of shares, once sold, are gone forever—along with all future growth and income they would have generated.

Risk Mitigation Strategies

As retirement approaches, investors should implement specific strategies to address sequence of returns risk and other retirement-specific challenges:

1. Gradually Reduce Portfolio Volatility

The traditional approach of decreasing equity exposure as retirement nears remains sound advice but requires nuance. Rather than following the oversimplified "100 minus your age" rule of thumb for equity allocation, one might consider a more targeted risk-reduction strategy:

• Maintain sufficient equity exposure to provide long-term growth that outpaces inflation

• Reduce exposure to the most volatile market segments (small caps, emerging markets, etc.)

• Focus on quality companies with strong balance sheets and consistent dividends

• Consider low-volatility equity strategies specifically designed to reduce downside risk. Investment Research Partners offers a variety of risk-managed equity solutions you might want to consider

2. Build a Retirement Income Buffer

Creating a dedicated income buffer can protect against the need to sell investments during market downturns:

• Establish a cash reserve covering 1-2 years of expenses beyond Social Security and pension income

• Construct a bond ladder with maturities timed to provide income for years 3-5 of retirement

• This approach could allow an investor’s equity investments time to recover from market corrections

3. Implement a Dynamic Withdrawal Strategy

Rather than adhering to rigid withdrawal rules, adjust spending based on market conditions:

• Reduce discretionary spending during market downturns to preserve capital

• Consider temporary withdrawal reductions during significant bear markets

• Potentially increase withdrawals during strong market periods to enjoy retirement while creating flexibility for future adjustments

4. Diversify Income Sources

Relying solely on portfolio withdrawals creates maximum exposure to sequence risk. Alternative income sources can provide stability:

• Explore dividend-focused investments that may provide more stable income

• Evaluate real estate investments that generate rental income independent of financial market fluctuations

• Explore part-time work during early retirement years to reduce withdrawal needs during the critical early period

5. Tax-Efficient Withdrawal Sequencing

The order in which you draw from various accounts can significantly impact both tax efficiency and risk mitigation:

• During market downturns, consider drawing from cash reserves or tax-advantaged accounts

• In strong markets, consider Roth conversions or capital gains harvesting at favorable tax rates

• Coordinate withdrawals with Social Security claiming strategies to optimize lifetime benefits

Practical Application: A Pre-Retirement Checklist

As you approach retirement, consider this risk-mitigation checklist:

The Psychological Dimension of Retirement Risk

Beyond financial mechanics, successful retirement risk management requires psychological preparation. The transition from accumulating wealth to spending it represents a profound mental shift that many retirees find challenging.

Many retirees actually underspend in retirement due to fears of market downturns and running out of money. This "retirement spending gap" creates a different kind of risk—sacrificing quality of life unnecessarily due to financial anxiety.

Proper risk mitigation could address both aspects: protecting against genuine financial risks while providing confidence to enjoy retirement without undue worry about normal market fluctuations.

Conclusion: Preserving What You've Built

After decades of disciplined saving and investing, the transition to retirement represents the culmination of one’s financial journey. The strategies that built your nest egg—dollar-cost averaging, long-term growth focus, and embracing market volatility—should evolve to protect what you've accumulated.

Sequence of returns risk stands as the most significant threat to retirement security, but it can be effectively managed through proper planning. By implementing a comprehensive risk mitigation strategy in the years leading up to retirement, investors can significantly improve their odds of maintaining financial independence throughout retirement, regardless of market conditions.

The key is recognizing that retirement investing requires a fundamentally different approach than accumulation. For those nearing this critical transition, working with financial professionals who specialize in retirement income planning can provide valuable guidance in navigating these complex waters and ensuring your financial security throughout your retirement years.

Important Disclosures

Past performance may not be representative of future results. All investments are subject to loss. Forecasts regarding the market or economy are subject to a wide range of possible outcomes. The views presented in this market update may prove to be inaccurate for a variety of factors. These views are as of the date listed above and are subject to change based on changes in fundamental economic or market-related data. The ETFs presented above are not intended to be benchmarks for performance.  Rather, they are intended to be demonstrative of a particular sector or segment the investment universe discussed.  Each ETF was selected as opposed to an index to more accurately reflect what an investor might experience.  There are other ETFs or indices that might be representative of the same spaces.  However, we believe the ones shown are sufficiently representative to assist us in explaining our investment thesis. Please contact your Advisor in order to complete an updated risk assessment to ensure that your investment allocation is appropriate.