Why is it essential to understand sequence of return risk when planning retirement withdrawals, particularly in the early years?

Sequence of return risk refers to the danger of experiencing negative investment returns early in retirement, which can severely deplete a retirement portfolio's longevity. In the early years of retirement, withdrawals are generally higher as a percentage of the portfolio, and negative returns during this period force retirees to sell off a larger number of shares to meet their income needs. This locks in losses and reduces the portfolio's ability to recover during subsequent market upturns. The impact is magnified because these early withdrawals and losses significantly diminish the principal balance from which future growth can occur. For example, if a retiree experiences a significant market downturn in the first few years and is forced to withdraw funds during this period, it becomes increasingly difficult for the portfolio to recover, even if the market subsequently performs well. Understanding sequence of return risk allows retirees to develop strategies like maintaining a more conservative asset allocation, using a variable withdrawal strategy that adjusts for market performance, or securing guaranteed income streams to mitigate the impact of early negative returns on their retirement funds.