Robinson Crothers: When Timing Is Everything: The Retirement Risk Hiding in Plain Sight

When Timing Is Everything: The Retirement Risk Hiding in Plain Sight

If you ask most people what determines whether their savings will last through retirement, you'll usually hear two answers: how much they saved and what kind of return they earned along the way. Both factors matter enormously, and for investors in the “accumulation” phase of their lives (when the focus is on saving and investing rather than withdrawals), contributions and average returns represent the only major drivers of their investment experience.

However, once investors enter the “retirement red zone” (roughly five years before and five years after retiring), there's a third factor that receives very little attention but can quietly make or break a retirement plan: the order in which those returns arrive.

Financial planners call it “sequence-of-returns” risk, and it's one of the most underappreciated threats a retiree faces. This risk means that two people can save the same amount and earn the exact same average return over their retirement, yet end up in completely different places: one comfortable well into their nineties, the other running short in their mid- or late seventies. The difference has nothing to do with the returns they achieve, but the timing of those returns.

Average Returns Don’t Always Tell the Whole Story

Here's the idea in plain terms. Imagine two investors, both retiring with $1 million, both planning to withdraw about $50,000 a year to supplement Social Security, and both destined to earn an average return of 7% a year over the next 25 years. On paper, they look identical, and at first glance, you would expect their retirement experiences to play out the same.

However, suppose the first investor retires into a rough couple of years of market returns: the market drops sharply right out of the gate and only later enjoys strong-return years. The second investor gets the mirror image: strong returns early, while the bad years don't show up until later. These two investors could average the same level of returns and withdraw the same amount of funds, but experience wildly different outcomes.

The investor who hits turbulence early may watch their portfolio shrink to a point from which it never fully recovers, while the one who catches an early tailwind could end up leaving their beneficiaries with far more assets than they had when they started retirement.

Why the Order Matters

To understand why timing suddenly becomes so powerful in retirement, it helps to see what's different about the years when you're saving versus the years when you're spending.

While you're still working and contributing, the order of returns barely matters. If your 401(k) drops 30% in a bad year, you’re probably not going to be happy, but you're not selling. Typically, you’re buying more as you make your monthly contributions. You have time, you're still adding money, and a down market even lets you buy in at lower prices. Over a long enough horizon, the timing of returns tends to roughly net out, and your investing experience largely mirrors the average return you achieved over your accumulation phase.

Retirement flips that logic on its head. Now you're not adding money; instead, you're taking it out. When you're forced to sell investments to fund your living expenses during a downturn, you lock in those losses permanently. You're selling more shares to raise the same amount of cash, which means fewer shares are left to recover when the market eventually turns.

Withdrawals and a falling market conspire together, and the damage compounds. You can think of this as the reverse of the concept of compound returns that creates so much wealth during your saving years. Instead of seeing a snowball effect of higher balances being available to generate ever-greater returns in dollar terms, you’re dealing with the opposite.

Consider the arithmetic of a single bad year. A $1 million portfolio that falls 30%, down to $700,000, needs roughly 43% just to get back to even. The math gets even uglier when you factor in withdrawals. Say you need $50,000 to live on, so you pull it out and you're left with $650,000. To climb back to your original $1 million, $650,000 now has to grow by nearly 54%.

Remember, a retiree will also need to withdraw another $50,000 the next year as well. It’s not hard to see how this could spiral and create a hole that is difficult or impossible to dig out of. Experience something like that in the first few years of retirement, and you may never catch up.

The “Retirement Red Zone”

The good news? The danger isn't spread evenly across your retirement years. It's concentrated in a specific window spanning roughly five years before and five years after you stop working. Some advisors call this the “retirement red zone,” and it's when sequence risk is most impactful to your retirement experience.

The reason is simple: this is the moment your portfolio tends to be near its largest, and it's the moment you begin drawing it down. A serious market decline in the years just before you retire, or in your first few years of withdrawals, does disproportionate harm. The very same decline ten or fifteen years later, after your account has had time to grow and your withdrawal habits are established, is far more survivable.

That's why the transition into retirement deserves more care and attention than almost any other financial decision you'll make.

How to Manage This Risk

The good news is that sequence risk, while impossible to eliminate, can be managed. You can't control what the market does the year you retire. You can control how exposed you are to it.

Typically, the strategies for mitigating this risk are based around tactically reducing risk as you enter the “retirement red zone,” leaning on “guaranteed” income streams, and dynamically adjusting your withdrawals. An effective plan to mitigate sequence-of-returns risk will likely combine all of these approaches while also balancing this risk against other factors such as opportunity costs, inflation, and longevity risk.

One of the most effective defenses is having a meaningful “cushion” in cash and short-term, stable investments. The purpose is straightforward: when stocks fall, you spend from the cushion instead of selling shares at depressed prices, giving your equity investments room to recover.

Some people think of this as a “bucket” approach, separating money you'll need soon from money you can leave invested for the long haul. In years of weak market performance, this bucket can be drawn down, and in years of strong performance, it can be refilled.

Building a “cushion” of liquid and safe assets should be viewed as part of a wider effort to pare back risk as you get closer to the finish line. While many investors want to see strong returns to close out their accumulation phase, it often makes sense to dial back risk as you approach the “red zone,” then let it drift back up once you're safely through the most vulnerable stretch.

Additionally, throughout the early part of retirement, investors may also consider implementing a “counter-cyclical” overlay on their asset allocation approach, proactively reducing risk during strong markets, then adding it back during periods of market drawdown. Being appropriately diversified and maintaining a proper asset allocation is always vital, but the importance is heightened in those crucial years just before and after retirement.

Another important tool is to utilize a dynamic withdrawal strategy. Retirees who can trim their spending modestly in bad years—skipping the inflation raise, deferring a big discretionary purchase, or implementing other cutbacks—dramatically improve the odds that their money lasts.

Some planners build in formal “guardrails” that adjust withdrawals up or down based on how the portfolio is performing. The willingness to spend a little less when the market is down is one of the most powerful tools a retiree has.

Another common solution is to lean on “guaranteed” sources of income for a large share of your annual withdrawals. Every dollar of guaranteed income, such as Social Security, a pension, or income annuities, is a dollar you don't have to pull from your investment accounts in a down market.

The Bottom Line

While it is important not to minimize the discipline, patience, and sacrifice required to invest for retirement over a multi-decade career, the formula is rather simple: consistently contribute as much as possible to your retirement accounts in the most tax-efficient manner.

An investor who does this will see good years and bad, but history shows that capital markets tend to handsomely reward investors over the long term. However, as investors transition from their “accumulation” phase into the withdrawal phase of their investing lives, the situation grows more complex, and the risks both evolve and multiply.

We spend our working lives focused on the two big questions: How much am I saving, and what return am I getting? Those questions never stop mattering, but in the years just before and after retirement, new questions emerge.

Sequence-of-returns risk is a reminder that a retirement plan built only on average returns is built on an incomplete foundation. Real markets don't deliver smooth, average years; they deliver good stretches and bad ones in an order nobody can predict. A sound plan doesn't try to forecast that order; instead, it’s built to survive a period in which the order of returns moves against you.

If you're within a few years of retirement on either side, it's worth sitting down with a financial professional to stress-test your plan against the potential for a rocky start. Getting the timing question right may matter just as much as all those years of diligent saving that got you here.

Robinson Crothers is Managing Partner at Great South Bay Advisors in Holbrook. This column is for general educational purposes and is not individualized investment, tax, or legal advice. Securities and investment advisory services offered through Osaic Wealth, Inc., Member FINRA/SIPC. Great South Bay Advisors and Osaic Wealth, Inc. are not affiliated.