Most people planning for retirement focus on average returns, such as what a reasonable long-term growth rate might be for a portfolio. That’s a useful question while you’re still saving. But once you start withdrawing money from a portfolio in retirement, a different and less intuitive factor becomes just as important as the average return: the specific order in which good and bad years happen. This is known as sequence-of-returns risk, and it can dramatically change retirement outcomes even when the long-run average return is identical.

Understanding why this happens, and why it matters most in a specific window right around retirement, is one of the more important, and more overlooked, concepts in retirement income planning.

What Sequence-of-Returns Risk Actually Is

While you’re saving and adding new money to a portfolio, the order of good and bad years doesn’t matter much to your final result. What matters is the average return over the whole period. But once you start taking withdrawals to cover living expenses, that stops being true. Withdrawing money during a down market means you’re selling more shares to generate the same dollar amount, permanently locking in losses on money that’s now gone and can’t participate in the eventual recovery. The order in which returns arrive, not just their average, starts to matter enormously.

A Simple Illustration

Imagine two retirees who each start with the same size portfolio and withdraw the same fixed dollar amount every year, and who experience the exact same set of annual returns over a 20-year retirement, just in opposite order. Retiree A gets a run of strong returns in the first several years, followed by weaker or negative years later. Retiree B experiences the identical returns, but in reverse: the weak and negative years come first, followed by the strong years later.

Even though both retirees experienced the exact same average return over the full 20 years, their outcomes can be wildly different. Retiree A, who had strong early growth, built up a cushion before the weaker years arrived, and the fixed withdrawals became a smaller percentage of a larger portfolio by the time the bad years hit. Retiree B, who had to take the same fixed withdrawals during the early down years, was forced to sell a larger share of a shrinking portfolio precisely when it was most vulnerable. Even when the strong years eventually arrived later, there was a smaller portfolio left to benefit from them. In some versions of this example, Retiree B’s portfolio runs out of money entirely, while Retiree A’s does not, despite both having experienced the identical average return.

Why the First Few Years of Retirement Matter Most

This risk isn’t spread evenly across a retirement. It’s concentrated in a specific window sometimes called the retirement red zone: roughly the five to ten years immediately before and after you stop working. During this stretch, the portfolio is typically at or near its largest size, and withdrawals are just beginning, so a market downturn during this window does the most permanent damage. A downturn of the same size that happens ten or fifteen years into retirement, once the portfolio has already had years to potentially grow, tends to be far less damaging, since there’s been more time for gains to offset it and the withdrawal-driven share sales aren’t compounding a loss from the very start.

How Guaranteed Income Can Help Address This Risk

One of the more direct ways to manage sequence-of-returns risk is to reduce how much you need to withdraw from market-exposed investments during a downturn in the first place. This is where guaranteed-income products like annuities can play a role. By covering a baseline level of essential expenses through an income stream that isn’t tied to market performance, an annuity can reduce the pressure to sell investments at depressed prices during a bad market stretch, particularly in those critical early retirement years. The market-exposed portion of the portfolio is then free to ride out the downturn rather than being drawn down at the worst possible time, which can meaningfully improve the odds that the overall plan holds up over a multi-decade retirement.

Planning Around It

Sequence-of-returns risk is a reminder that average returns alone don’t tell the whole story once withdrawals begin. Building a retirement income plan that accounts for the possibility of poor returns in the early years, whether through a more conservative withdrawal strategy, a cash reserve for down markets, guaranteed income sources, or some combination, is one of the more valuable things a retiree can do before those first, most vulnerable years arrive.

This article is for general educational purposes and does not constitute personalized financial, tax, or legal advice. Insurance products, features, costs, and availability vary by carrier and state. Speak with a licensed advisor about your specific situation before making a decision.