Bumpy markets are no fun for anyone, but for clients about to retire or who are recently retired, volatility can be downright terrifying. That’s because market drops right before or early in someone’s retirement make it difficult for them to make up the returns later—a phenomenon called “sequence of returns” risk.
“We’re really vulnerable to market returns around the retirement date—in the years leading up to retirement and then especially in the early years of retirement,” said Wade Pfau, a Dallas-based retirement specialist who spoke about sequence risk strategies in a webinar on Wednesday.
“It’s not just the average return over your retirement that’s going to determine the success or failure of the plan. It’s the order that the returns come,” he said. “Bad returns early on balanced by good returns later on can’t help you. If you get good returns early on, balanced by bad returns later on, you’re smooth sailing.”
One of the problems for these investors is that they want to avoid selling assets at a loss, yet retirees taking distributions have to sell assets in every market.
There are three aspects of sequence risk particularly difficult to address, he said. The first is that there’s no way to predict when those poor returns will come. The second is that sequence risk can’t be managed through diversification—it needs its own intentional strategy. And the third is that simple withdrawal strategies—say, taking 5% every year for the historical average return—will fail at some point.
“Even if the average return is right over a long period, markets are volatile, and that volatility is going to have an impact on you,” he said.
Pfau suggested advisors consider four very different techniques—all of which can accomplish the goal of protecting clients from sequence risk.
One is to spend conservatively. The second is to use a flexible spending strategy. The third is to reduce portfolio volatility. And the fourth is to use a buffer asset during periods of poor returns.
Spending Conservatively
While penny-pinching frugality is no retiree’s idea of a good time, Pfau was adamant that small adjustments can do the trick here.
He said that to do this efficiently, retirees can delay Social Security until they are age 70 and build a bridge to cover their spending between the day they retire and the day they start collecting.
He shared the hypothetical case of a single client who wants to retire at age 62. The client has $866,000 in retirement assets and an annual spending goal of $60,000, adjusted for inflation. The client’s two income sources would be the retirement assets and Social Security.
By taking the Social Security benefit at age 62, this client gets $21,000 a year, and is also pulling $39,000 a year from investments to meet spending goals (a 4.5% withdrawal rate). If the client delays Social Security to 70, they’d get $37,200 and would have to take just $22,800 from investments, a 3.89% withdrawal rate.
The trick would be getting through those eight years between the date of retirement at 62 and the date of taking Social Security benefits at 70—and doing so in a way that sidesteps sequence risk.
“Their solution’s not going to be to take $60,000 a year straight up from their total return diversified investment portfolio, which would amplify sequence risk,” Pfau said.
Instead, the client could find ways around the risk by using something like Treasury Inflation-Protected Securities (TIPS), which are U.S. Treasury bonds that provide inflation adjustments. An eight-year bond ladder would give the client $37,000 per year (adjusted for inflation) to match the missing Social Security benefit until it kicks in when the client turns 70.
The result is a portfolio with greater longevity. If the client takes Social Security at age 62 and pulls from his or her investment portfolio to make up the $60,000 over eight years, this would deplete the client’s assets in 19, leaving the client with just the $21,000 from Social Security to live on after that. But when the Social Security benefit is delayed, the client’s assets would deplete after 25 years, and they’d have a much larger benefit at the end.
“They still run out their portfolio, but it’s not the same. Not only does the portfolio last seven years longer, but Social Security is going to give them $37,200 a year plus inflation,” Pfau said. “They still get a much higher spending amount for the remainder of their retirement.”
Flexible Spending Strategies
The second approach is the flexible spending strategy. Here, retirees spend more in market upturns and less in market downturns. That way they can avoid selling as many assets at a loss.
“This is the complete opposite of the 4% rule idea, which is just about how much you spend in the initial year, and then you adjust that amount for inflation,” Pfau said. That amount is a fixed dollar amount every year (say, $40,000 every year if you have started with a $1 million portfolio), plus the inflation adjustment.
Instead, what if a client spent 6% (or 8%) of whatever is in their portfolio for each year, whether the portfolio had gone up or down?
“We’re going to call that the constant percentage strategy. And that’s the exact opposite of the constant amount strategy. You spend a constant percentage of what’s left, and you don’t worry about what amount that is,” Pfau said.
If the markets do well and the portfolio is up, the client can spend more. If markets do poorly, the client is using the same percentage of a smaller pie and spends less.
“You never run out of money with a constant percentage strategy, even with a 10% annual distribution rate,” Pfau said. The only problem, he continued, is that spending amounts can vary dramatically, dropping as much as 60% in a very down market.
Because of this, Pfau said he doesn’t advocate a pure constant percentage strategy. Instead, he said flexible spending strategies should be a compromise between the extreme of 4% of the initial portfolio with no adjustments and a fixed percentage of the remaining balance of the portfolio with constant adjustments based on market performance.
Pfau compared seven different flexible spending strategies with initial spending rates from 3.88% to 8.97%, all of which took a retiree to age 95 without completely running out of money. The most conservative of them even had a portfolio of almost $475,000 left over.
Reduce Portfolio Volatility
Technically, an investor could completely eliminate volatility by building a 30-year bond ladder in which the yield curve dictates how much can be spent and the investor would be at zero at the end of 30 years, Pfau said.
But a better option is to reduce volatility more in the context of a diversified portfolio with growth still part of the mix.
“It saves you from getting into those downward spirals where your portfolio just plummets towards zero,” Pfau said. “By taking away 10% of the volatility in those returns, instead of ending up at zero, we have $1.6 million after 30 years,” he said.
To do this, Pfau said he likes a technique called the “rising equity glide path.”
Here, the retiree can start retirement with a lower stock allocation—in keeping with the conventional wisdom that the equity portion of a portfolio should drop the closer someone is to retirement. But then the stock allocation would increase again throughout retirement.
This would help the retiree reduce the sequence risk: If their portfolio is battered by a down market when it has a lower allocation to stocks, it recovers through the combination of the eventual rising market and a simultaneous increase in equities.
“Now, behaviorally, this won’t appeal to everyone because it can be tough to increase your stock allocation in advanced ages. So I’m not advocating this for everyone,” he said. “But I have heard from plenty of people where this really resonates.”
Use A Buffer Asset
With this technique, the retiree holds an asset outside of the portfolio that does not decline in value along with the overall markets and then taps it if necessary to avoid selling portfolio assets at a loss.
In essence, it gives the person a temporary bridge that allows them to skip a year of spending when the portfolio is at its lowest.
When you look back at historical data from 1966 to 1995, the S&P 500 was down in 1966, 1969, 1973 and 1974. Pfau considered what would have happened to a portfolio if distributions were not taken for the one year following one of those downturns.
“Well, that means the difference between ending up at zero and still having more than $800,000 left at the end of 1995. And if we had some buffer asset that let us skip the distribution in all four of those years after downturns, well, that would be the difference between ending up with zero at the end and still having $4 million at the end,” he said.
While some buffer assets can look expensive at face value, as long as it costs less than $4 million, the retiree can pay off the debt on the buffer asset and still have a large windfall left as additional assets for heirs or philanthropy, he said.
Pfau said there are only three types of buffer assets that he’s comfortable considering: One is cash. The second is a variable rate home equity conversion mortgage or reverse mortgage. And the third is the cash value of a whole life or permanent life insurance policy (or the amount borrowed against it).
“The idea is if my portfolio looks to be in trouble, I’ll temporarily tap into the buffer asset to meet expenses, giving that portfolio an opportunity to recover,” he said, adding that the reverse mortgage could potentially work with the other approaches to managing sequence risk as well.
“Instead of having to create a Social Security delay bridge by selling from your portfolio, you could use an eight-year term payment from a reverse mortgage to help meet some of that missing Social Security benefit,” he said. “Or you could add a 10-year payment from a reverse mortgage that reduces the distribution rate from your other investments. Or you could use the portfolio coordination buffer asset idea where you draw from the line of credit when markets are down to help protect your portfolio. There are a lot of different ways that a reverse mortgage could fit into the conversation on reducing sequence-of-returns risk in retirement.”
July 17, 2025 • Jennifer Lea Reed
