Sequence of Returns Risk: The Hidden Danger in Early Retirement

The order in which you experience investment returns can be just as important as the average return itself, especially in early retirement. This phenomenon, known as sequence of returns risk, is one of the most critical yet least understood risks in retirement planning.

What is Sequence of Returns Risk?

Sequence of returns risk refers to the danger of experiencing poor investment returns early in retirement when you're also withdrawing money from your portfolio. The combination of market losses and withdrawals can permanently damage your portfolio's ability to recover, even if returns improve later.

This risk is unique to the withdrawal phase of retirement. During the accumulation phase (while you're working and saving), the sequence of returns doesn't matter much—you're buying more shares when prices are low and fewer when prices are high, which works in your favor over time.

A Tale of Two Retirees

Consider two retirees, both starting with $1 million and withdrawing $40,000 annually (4% initial withdrawal rate). Both experience the exact same returns over 30 years, averaging 7% annually. The only difference is the order of returns:

Retiree A experiences poor returns early (-10%, -5%, +2%) followed by good returns later (+15%, +12%, +10%).

Retiree B experiences the exact opposite: good returns early (+15%, +12%, +10%) followed by poor returns later (-10%, -5%, +2%).

Despite having identical average returns, Retiree A runs out of money in year 23, while Retiree B ends with over $2 million. This dramatic difference is entirely due to the sequence of returns.

Why Early Returns Matter So Much

When you experience losses early in retirement while taking withdrawals, you're forced to sell more shares to generate the same dollar amount. These shares are gone forever and can't participate in future market recoveries.

For example, if your portfolio drops 20% and you withdraw $40,000, you're withdrawing 5% of your new, lower balance instead of 4% of your original balance. This accelerates portfolio depletion and reduces the base from which future returns can compound.

The Critical First Decade

Research shows that returns in the first 10 years of retirement have an outsized impact on long-term success. A bear market in years 1-3 of retirement can be devastating, while the same bear market in years 20-23 has much less impact because you've already benefited from years of positive returns and your withdrawal rate relative to your original portfolio is lower.

This is why retiring into a bull market versus a bear market can make such a dramatic difference in outcomes, even if long-term returns end up being similar.

Strategies to Mitigate Sequence Risk

1. Build a Cash Buffer

Keep 1-3 years of expenses in cash or short-term bonds. During market downturns, draw from this buffer instead of selling stocks at depressed prices. Replenish the buffer during good years.

2. Use a Bucket Strategy

Divide your portfolio into three buckets: short-term (1-3 years in cash/bonds), medium-term (4-10 years in balanced investments), and long-term (10+ years in stocks). Draw from the short-term bucket and refill it from the others during good market years.

3. Flexible Spending

Be willing to reduce discretionary spending during market downturns. Cutting spending by 10-20% during bear markets can significantly improve your portfolio's long-term sustainability.

4. Delay Retirement

If you're planning to retire and the market has recently experienced significant losses, consider working another year or two. This allows your portfolio to recover before you start withdrawals and reduces the number of years you need your money to last.

5. Lower Initial Withdrawal Rate

Starting with a 3-3.5% withdrawal rate instead of 4% provides more cushion against sequence risk. You can always increase spending later if returns are favorable.

6. Maintain Equity Exposure

While it might seem counterintuitive, maintaining 50-70% stocks throughout retirement helps ensure your portfolio can recover from downturns. Being too conservative can actually increase the risk of running out of money due to inflation.

7. Consider Annuities for Base Expenses

Using a portion of your portfolio to purchase an immediate annuity can provide guaranteed income to cover essential expenses, reducing the amount you need to withdraw from your portfolio during downturns.

The Role of Social Security

Social Security acts as a natural hedge against sequence risk because it provides guaranteed inflation-adjusted income regardless of market conditions. This is one reason why delaying Social Security can be valuable—it increases your guaranteed income floor and reduces your dependence on portfolio withdrawals.

Monitoring and Adjusting

Regularly review your portfolio's performance relative to your plan. If your portfolio value drops significantly below your original projections in the first few years of retirement, take action:

• Reduce discretionary spending
• Consider part-time work to reduce withdrawals
• Delay Social Security to increase future guaranteed income
• Reassess your withdrawal rate

Our retirement calculator includes Monte Carlo simulations that model sequence of returns risk across 1,000 different scenarios. Use it to understand how different market sequences could affect your retirement and test various mitigation strategies.