The Sequence of Returns Risk: Why Your First 5 Years Matter Most

Two retirees can retire on the same day with identical portfolios and the same average annual return over twenty years, and still end up in very different financial positions. The difference often comes down to timing: when the good years and bad years happen relative to when withdrawals begin. This is called sequence of returns risk, and it is one of the most overlooked threats to a retirement income plan.

Understanding this risk matters most in a specific window: roughly five years before retirement through the first five to ten years after. During this stretch, a market downturn does far more damage than the identical downturn would do earlier in your career or later in retirement. The reason is simple but easy to miss: you are now withdrawing money at the same time the portfolio is trying to recover.

Key Takeaways

• Average return over a retirement horizon does not tell the whole story. The order returns occur in matters just as much, according to Investor.gov.
• Withdrawing from a portfolio during a downturn forces you to sell more shares to raise the same amount of cash, leaving fewer assets to participate in a later recovery.
• The SEC's investor guidance notes many experts suggest conservative withdrawal rates, often in the 3% to 5% range, particularly in the early retirement years.
• A cash and bond reserve, flexible withdrawal rates, and a written income plan are practical ways to reduce exposure to this risk.
• The “first five years” framing is a planning heuristic used widely by advisors and researchers, not a government-mandated rule.

What Is Sequence of Returns Risk?

Sequence of returns risk describes what happens when poor investment returns occur early in retirement at the same time you are drawing income from your portfolio. Investor.gov, the SEC's investor education site, defines this as the risk that the timing of returns, not just their average, can affect how long a portfolio lasts.

During your working years, while you are contributing to savings rather than withdrawing from them, the order of returns matters much less. A down year followed by an up year generally nets out close to an up year followed by a down year, because there are no withdrawals forcing you to lock in losses. Once withdrawals begin, that symmetry breaks down. Selling shares after a decline to generate income permanently reduces the number of shares left to benefit from the eventual recovery.

Why the First Five Years Matter More Than the Rest

The years immediately before and after retirement are often called the retirement red zone by planners, because a portfolio is typically at its largest dollar value right when withdrawals start, and there is no longer a paycheck to cushion a downturn. The SEC specifically cautions retirees to consider more conservative withdrawal approaches in these early years, when market swings and return uncertainty carry the most weight.

There is no single government-mandated cutoff that defines this window. Different researchers describe it as the first five years of retirement, the first five to ten years, or the five years before and five years after the retirement date. Regardless of the exact boundary, the underlying idea is consistent: the earlier in retirement a downturn hits while withdrawals are underway, the more lasting the damage tends to be, because there are fewer remaining years for the portfolio to recover and fewer future contributions to offset the loss.

A Simple Hypothetical Comparison

Consider two hypothetical retirees, each starting with the same portfolio balance and each withdrawing the same income each year, adjusted for inflation. Over a twenty year retirement, both portfolios experience the exact same set of annual returns, just in a different order.

Retiree A experiences several strong market years right at the start of retirement, followed later by a rough stretch. Because the portfolio grew before the downturn arrived, withdrawals in the weaker years came from a larger base, and the account was able to absorb the dip.

Retiree B experiences the same rough stretch first, in years one through five, before the strong years arrive later. Because withdrawals were being taken while the portfolio was already shrinking, more shares had to be sold at lower prices to generate the same income. By the time the strong years finally showed up, there was a smaller base left to benefit from them.

“Both retirees earned the exact same average annual return over the full twenty years. Only the order was different.”

Yet Retiree B could end up with meaningfully less money, or could even run out of savings earlier, purely because of when the weak years landed. This illustration is hypothetical and is meant only to demonstrate the mechanics of sequencing, not to predict any specific market outcome or guarantee any result.

Practical Ways to Manage This Risk

While no one can control when markets rise or fall, there are concrete steps pre-retirees and retirees can put in place well before this window opens.

Build a Cash and Bond Reserve (the Bucket Strategy)

One widely used approach involves setting aside enough cash and short-term, high-quality bonds to cover several years of planned withdrawals. The idea is that if equities decline, you can draw from the reserve instead of selling stocks at depressed prices, giving the equity portion of the portfolio time to recover before it is tapped again.

Use a Flexible, Rather Than Fixed, Withdrawal Rate

A rigid withdrawal amount that increases with inflation every year regardless of market conditions can compound the damage of an early downturn. A more flexible approach, such as trimming withdrawals modestly in a down year or delaying a planned increase, can reduce how much is sold at depressed prices.

Maintain Diversification Across Asset Classes

Spreading assets across different types of investments, rather than concentrating in a single asset class, can help reduce the chance that a single market decline forces withdrawals from the worst-performing part of the portfolio at the worst possible time.

Consider Delaying or Phasing Into Retirement

For those with flexibility, working a bit longer, reducing hours, or transitioning gradually rather than retiring on a single date can shrink the number of years a portfolio is exposed to early sequence risk, and can also reduce how much needs to be withdrawn in those critical first years.

Put the Plan in Writing and Revisit It Regularly

A written retirement income plan that spells out withdrawal order across taxable, tax-deferred, and Roth accounts, along with rules for when to draw down the cash reserve and when to refill it, gives you something concrete to follow in a downturn instead of making decisions under stress. Ongoing portfolio monitoring in the years immediately before and after retirement is particularly important, since this is when the stakes of sequencing are highest.

Common Mistakes to Avoid

• Focusing only on average expected return and ignoring how the order of returns could play out.
• Keeping no cash or short-term reserve, forcing every withdrawal to come directly from invested assets.
• Sticking rigidly to a fixed withdrawal amount during a market decline rather than building in flexibility.
• Retiring all at once with the full portfolio exposed, when a phased approach might reduce risk.
• Treating the retirement date as a one-time decision rather than revisiting the income plan regularly in the years around retirement.

When to Talk With Us

Sequence of returns risk is not something a household can eliminate, but it is something that can be planned for. If you are within five to ten years of retiring, already retired, or guiding a business succession that will affect your own retirement timeline, it is worth reviewing how your current withdrawal strategy, cash reserves, and asset allocation would hold up against an early downturn. Every family's situation is different, and a personalized retirement income plan looks different depending on your goals, other income sources, and risk tolerance. If you would like to talk through how this applies to your own plan, we welcome the conversation.

Frequently Asked Questions

• Is the “first five years” a hard rule retirees must follow? No. It is a planning heuristic used by advisors and researchers to describe the window when a portfolio is most vulnerable to withdrawals combined with poor returns. No government source establishes a universal five-year requirement.
• Does sequence of returns risk matter while I'm still working and saving? Much less so. Without withdrawals, the order of returns generally has little effect on the ending value for a given set of returns. The risk becomes significant once regular withdrawals begin.
• What withdrawal rate does the SEC suggest for early retirement? The SEC's investor guidance notes many experts recommend annual withdrawals in the range of 3% to 5%, particularly in the first years of retirement, while acknowledging there is no universally accepted rate.
• How much cash should I keep in reserve? There is no single regulator-mandated amount. Approaches vary, and the right figure depends on your specific income needs, other guaranteed income, and risk tolerance. This is a conversation worth having directly with an advisor.
• Can diversification alone eliminate this risk? No single strategy eliminates sequence of returns risk entirely. Diversification, a cash reserve, flexible withdrawals, and a written plan are complementary tools, not guarantees.
• What happens if I withdraw funds from a retirement account before age 59½? Withdrawals from qualified retirement plans before age 59½ generally face an additional 10% tax under Internal Revenue Code §72(t), subject to certain exceptions.
• Are substantially equal periodic payments relevant here? For those considering early withdrawals penalty-free, substantially equal periodic payments generally must continue for five years or until age 59½, whichever is longer, under IRS rules. This is a different five-year concept than the sequence of returns planning window and should be reviewed carefully with a tax professional before use.
• Does a strong first few years of retirement guarantee success? No. A favorable early sequence does not guarantee a successful retirement, just as an unfavorable one does not automatically mean failure. Spending, asset allocation, taxes, longevity, and inflation all play a role.
• Should I delay retirement to reduce this risk? For some households, working longer or phasing into retirement can reduce the number of years exposed to early sequence risk and may also reduce how much needs to be withdrawn initially. Whether this makes sense depends on individual circumstances.
• How often should my retirement income plan be reviewed? Ongoing monitoring is particularly important in the years immediately before and after retirement, when the stakes of sequencing are highest. Reviewing the plan regularly, rather than treating the retirement date as a single decision point, is a widely recommended practice.

Sources

• Investor.gov, Sequence of Returns Risk
• SEC, Spending Your Retirement Savings Wisely
• IRS Publication 590-B