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Sequence-of-returns risk is the danger that poor investment returns in the first years of retirement, combined with portfolio withdrawals, permanently weaken a portfolio’s ability to fund later spending. Two portfolios can earn the same set of annual returns and finish with very different balances when those returns occur in a different order.
The practical response is not to abandon every risky asset. Retirees generally manage the risk by coordinating their asset mix, near-term spending reserves, withdrawal rules and willingness to adjust spending when markets fall. Each approach changes the trade-offs; none removes uncertainty or guarantees that savings will last.
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How sequence-of-returns risk works
During the saving years, contributions can offset some of the damage from a market decline. In retirement, the cash flow usually reverses: money is withdrawn to pay bills. A fall in the account value therefore has two effects. The portfolio loses value, and the withdrawal removes assets that otherwise could have participated in a later recovery.
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That is why a long-term average return does not describe the path of retirement income. The order of gains and losses matters most when withdrawals are already taking place. A retiree who experiences several strong years before a downturn may have a larger balance when the downturn arrives. Someone with the same investments and the same eventual average return, but losses at the beginning, may have fewer assets left to recover.
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A simple return-order illustration
Morningstar illustrated the timing effect with a $10,000 starting balance, $1,000 annual withdrawals and three annual returns. With returns of 10%, 10% and then −10%, the account ends at $8,000. Reversing the order of those same returns produces an ending value of $7,580 in the article’s illustration.
The example is a demonstration of cash-flow timing, not a forecast or an investment recommendation. Actual outcomes depend on when withdrawals occur, inflation, fees, taxes, asset allocation and the length of retirement.
Why the retirement transition is vulnerable
The years immediately before and after leaving work are often called the retirement risk zone. Vanguard describes this period as vulnerable because necessary withdrawals can reduce the assets available for a subsequent market recovery. A downturn later in retirement may matter less if the portfolio has already demonstrated that it can support the spending plan and the retiree has fewer years of withdrawals ahead.
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1Repair Windows errors before they cause bigger problems2Fix the driver behind crashes, sound loss and screen glitches3Clear out junk files and repair common Windows errorsWade Pfau, a retirement researcher and author, described the mechanism in a Morningstar interview: “The sequence-of-returns risk idea comes up in the retirement context with the idea that, if you’re trying to meet a fixed spending goal in retirement, if there’s a market downturn early in retirement, that can dig a hole for your portfolio in a way that a market downturn later in retirement may have very little impact because you’ve already kind of figured out by that point whether you can spend a lot or a little.”
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Why an average return and a withdrawal rate are not enough
A withdrawal percentage is meaningful only with its assumptions attached. The relevant questions include:
- What mix of stocks, bonds, cash and other assets is being modeled?
- Are withdrawals fixed in dollars, increased with inflation or adjusted according to portfolio performance?
- How long is the modeled retirement?
- What probability of success is being targeted?
- Can the retiree reduce discretionary spending after a poor market year?
Morningstar’s 2025 retirement-income research reported a 3.4% starting spending rate for an all-equity portfolio with fixed real withdrawals, assuming a 90% probability that funds would remain at the end of an assumed 30-year retirement. That figure is a modeled result under those conditions, not a universally safe rate and not a personal prescription. Changing the asset mix, horizon, inflation method, spending flexibility or desired probability can change the result.
Morningstar also described an illustrative historical scenario using a $1 million initial portfolio, a $40,000 first-year withdrawal and 3% annual increases in withdrawals. It is a historical illustration of how a spending rule interacts with market returns, not a current recommendation.
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Strategies retirees can use to manage the risk
1. Diversify stocks and bonds
A diversified stock-and-bond allocation can reduce dependence on any single market and may buffer some equity volatility. Vanguard identifies diversification as an effective way to manage market swings and inflation. Bonds can provide a different return pattern from stocks, but they also carry interest-rate, credit and inflation risks; they do not guarantee positive results.
The appropriate mix depends on the spending plan, time horizon, risk capacity and other income sources. Holding too little growth exposure can increase the risk that inflation erodes purchasing power over a long retirement. Holding too much equity exposure can increase the size of an early decline. The objective is to make the overall plan workable, not to find an allocation that eliminates losses.
2. Keep a near-term cash reserve
Morningstar’s 2025 discussion describes holding one or two years of planned withdrawals in a separate cash bucket. If markets fall, that reserve can cover near-term spending without forcing an immediate sale of depressed investments.
A cash reserve is a liquidity technique, not a complete retirement strategy. Cash can lose purchasing power to inflation and may earn less than a diversified portfolio over long periods. The reserve also has to be replenished eventually, and a prolonged downturn can outlast one or two years of withdrawals. Decide in advance what counts as a planned withdrawal and how the bucket will be refilled.
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Flexible spending rules reduce withdrawals when the portfolio falls or when the withdrawal rate rises beyond a chosen boundary. Vanguard calls this dynamic spending; Morningstar discusses guardrails and other variable-withdrawal methods. The retiree might protect essential expenses while postponing travel, gifts or other discretionary purchases after a poor year.
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The benefit is that fewer assets are sold during a downturn. The cost is less predictable income. A rule is useful only if the household can follow it in practice, understands which expenses are adjustable and agrees on the trigger for a reduction or increase. A retiree who needs a fixed monthly amount for all expenses may have less flexibility than a household with substantial discretionary spending.
4. Use fixed real withdrawals knowingly
A fixed real withdrawal provides a steadier spending target by increasing the dollar amount with inflation. That stability can be valuable, but it places more pressure on the portfolio after early losses because the withdrawal does not automatically fall when the account declines. Any projected success rate for this method must state its asset mix, inflation treatment, horizon and probability assumptions.
Comparing the approaches
| Approach | How it may reduce selling after losses | Income and spending trade-off | Growth and inflation trade-off | Practical challenge |
|---|---|---|---|---|
| Diversified stock-and-bond allocation | A bond allocation may cushion some equity volatility. | Spending can remain more stable, but losses are still possible. | Maintains growth exposure while introducing bond and inflation risks. | The mix must fit the spending plan and other income sources. |
| One- or two-year cash reserve | Cash can fund planned withdrawals during a downturn. | Near-term spending is easier to maintain; the reserve must eventually be replenished. | Cash may lag a diversified portfolio and lose purchasing power to inflation. | Requires a process for defining, using and refilling the bucket. |
| Flexible or guardrail withdrawals | Lower withdrawals can leave more assets invested after a decline. | Income varies and discretionary spending may need to fall. | Preserves more capital for recovery but may reduce spending during weak markets. | Household members must accept and follow the adjustment rules. |
| Fixed real withdrawals | Does not reduce sales automatically after losses. | Offers a steadier inflation-adjusted spending target. | Can place greater pressure on a portfolio after early losses. | Success depends heavily on the modeled assumptions. |
How to build a sequence-aware retirement plan
- Separate essential and discretionary spending. List the annual amount needed for housing, food, health care and other necessities, then identify expenses that could be delayed or reduced. This determines how much flexibility a market downturn can create.
- Set a starting withdrawal amount. Express the first-year withdrawal as a percentage of the investable portfolio, but record the assumptions behind the figure. A rate taken from a study is not transferable without checking its horizon, asset mix, inflation method and success probability.
- Choose an asset allocation deliberately. Decide how much volatility the spending plan can withstand and how much growth may be needed to address inflation. Diversification can manage some market swings, but it cannot prevent losses.
- Decide whether a cash bucket fits. If using one, specify the number of years of planned withdrawals it covers, where the money is held and the conditions for spending it. Treat it as a liquidity reserve rather than a replacement for the rest of the portfolio.
- Write the adjustment rule before a downturn. For example, define whether discretionary spending falls after a specified portfolio decline or when the withdrawal rate crosses a chosen guardrail. The exact trigger is a planning decision, not a universal rule established by the cited studies.
- Coordinate withdrawals with the portfolio. In a weak market, the plan might draw from cash or less-depressed assets first, subject to the allocation’s rebalancing policy. Avoid making an improvised all-or-nothing change based on a single news event.
- Review on a regular schedule and after major changes. Revisit the plan when spending needs, market conditions or the retiree’s ability to adjust changes. Dynamic spending is an approach, not a guarantee that the portfolio will last.
What to do during an early-retirement downturn
First, compare the current portfolio value with the spending plan rather than reacting to headlines alone. Check how many months of planned withdrawals are available in cash or other liquid assets and identify which expenses can be postponed. Then apply the written withdrawal rule, if one exists.
Do not assume that selling every stock is automatically safer. A large unplanned shift can reduce long-term growth and create a new allocation problem. Likewise, do not assume that holding cash solves sequence risk: a downturn that lasts longer than the reserve, rising inflation or an inadequate starting portfolio can still threaten the plan.
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If the plan has no flexibility and the portfolio has fallen materially, the decision is not simply “wait for a recovery.” The available choices may include reducing discretionary spending, delaying a planned increase, using a reserve, changing the allocation in a controlled way or reassessing the starting withdrawal. The appropriate choice depends on the household’s circumstances.
Common mistakes
- Looking only at the average return. Averages hide the order of returns and the withdrawals that occur between them.
- Treating a published rate as a promise. The 3.4% Morningstar figure applies to an all-equity, fixed-real-withdrawal model with a 30-year horizon and a 90% modeled probability of funds remaining.
- Keeping an oversized cash balance indefinitely. Cash can reduce near-term selling pressure but may increase inflation and longevity risk if it displaces needed growth assets.
- Using a flexible rule without defining essential expenses. A vague promise to “spend less” is difficult to execute when markets are falling.
- Changing the entire portfolio after one bad year. Sequence management is about a coordinated spending and investment plan, not a single tactical reaction.
- Ignoring changing circumstances. A plan may need revision when health costs, family support, spending needs or the ability to make reductions changes.
Further reading
For a deeper treatment of retirement spending and sequence risk, Morningstar’s 2026 interview with Wade Pfau identifies Retirement Planning Guidebook, third edition. It is optional reading, not a requirement for creating a plan or a promise of an outcome.
All withdrawal rates and projected outcomes discussed here are scenario-dependent. They are useful for understanding trade-offs, but they do not replace a plan built around an individual household’s spending needs, assets, time horizon and tolerance for changing income.
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