Sequence of Returns Risk Explained
When you're saving for retirement, the order of your investment returns doesn't matter—only the average matters. A portfolio that gains 10%, loses 5%, and gains 15% ends up at the same place regardless of the sequence. But once you start withdrawing money, the order of returns becomes critical. This is sequence of returns risk, and it can determine whether your portfolio lasts 30 years or runs out in 20.
Why Order Matters During Withdrawals
When you withdraw money from a declining portfolio, you're selling shares at low prices. Those shares are no longer available to recover when markets bounce back. Early losses combined with withdrawals create a compounding drain on your portfolio that's difficult to overcome.
During accumulation, early losses are actually beneficial—you're buying shares at lower prices. During decumulation, early losses are harmful—you're selling shares at lower prices and reducing your base for future recovery.
The Mathematics of Sequence Risk
Consider two scenarios with identical average returns but opposite sequences:
Scenario A: Good returns early, bad returns late Scenario B: Bad returns early, good returns late
Both portfolios:
- Start with $1,000,000
- Withdraw $40,000 annually (4% initial withdrawal rate)
- Have the same 10 annual returns, just in different order
- Average return: 6% in both cases
Year-by-Year Comparison
| Year | Return (Scenario A) | Return (Scenario B) |
|---|---|---|
| 1 | +26% | -15% |
| 2 | +18% | -8% |
| 3 | +12% | -2% |
| 4 | +8% | +3% |
| 5 | +5% | +5% |
| 6 | +3% | +8% |
| 7 | -2% | +12% |
| 8 | -8% | +18% |
| 9 | -15% | +26% |
| 10 | +13% | +13% |
Average annual return for both: 6.0%
Scenario A: Good Returns Early
| Year | Start Balance | Return | After Return | Withdrawal | End Balance |
|---|---|---|---|---|---|
| 1 | $1,000,000 | +26% | $1,260,000 | $40,000 | $1,220,000 |
| 2 | $1,220,000 | +18% | $1,439,600 | $40,000 | $1,399,600 |
| 3 | $1,399,600 | +12% | $1,567,552 | $40,000 | $1,527,552 |
| 4 | $1,527,552 | +8% | $1,649,756 | $40,000 | $1,609,756 |
| 5 | $1,609,756 | +5% | $1,690,244 | $40,000 | $1,650,244 |
| 6 | $1,650,244 | +3% | $1,699,751 | $40,000 | $1,659,751 |
| 7 | $1,659,751 | -2% | $1,626,556 | $40,000 | $1,586,556 |
| 8 | $1,586,556 | -8% | $1,459,632 | $40,000 | $1,419,632 |
| 9 | $1,419,632 | -15% | $1,206,687 | $40,000 | $1,166,687 |
| 10 | $1,166,687 | +13% | $1,318,356 | $40,000 | $1,278,356 |
Final balance after 10 years: $1,278,356
Scenario B: Bad Returns Early
| Year | Start Balance | Return | After Return | Withdrawal | End Balance |
|---|---|---|---|---|---|
| 1 | $1,000,000 | -15% | $850,000 | $40,000 | $810,000 |
| 2 | $810,000 | -8% | $745,200 | $40,000 | $705,200 |
| 3 | $705,200 | -2% | $691,096 | $40,000 | $651,096 |
| 4 | $651,096 | +3% | $670,629 | $40,000 | $630,629 |
| 5 | $630,629 | +5% | $662,160 | $40,000 | $622,160 |
| 6 | $622,160 | +8% | $671,933 | $40,000 | $631,933 |
| 7 | $631,933 | +12% | $707,765 | $40,000 | $667,765 |
| 8 | $667,765 | +18% | $787,963 | $40,000 | $747,963 |
| 9 | $747,963 | +26% | $942,433 | $40,000 | $902,433 |
| 10 | $902,433 | +13% | $1,019,749 | $40,000 | $979,749 |
Final balance after 10 years: $979,749
The Impact
| Metric | Scenario A | Scenario B | Difference |
|---|---|---|---|
| Starting balance | $1,000,000 | $1,000,000 | $0 |
| Total withdrawals | $400,000 | $400,000 | $0 |
| Average return | 6.0% | 6.0% | 0% |
| Final balance | $1,278,356 | $979,749 | $298,607 |
Despite identical average returns, the portfolio with good returns early has $298,607 more after just 10 years. Over a 30-year retirement, this difference compounds dramatically and can mean the difference between portfolio success and depletion.
Extended Impact: 30-Year Projections
Extending these scenarios over a 30-year retirement (with returns repeating in the same pattern), the outcomes diverge significantly:
| Year | Scenario A Balance | Scenario B Balance |
|---|---|---|
| 10 | $1,278,356 | $979,749 |
| 15 | $1,456,000 | $872,000 |
| 20 | $1,589,000 | $698,000 |
| 25 | $1,692,000 | $443,000 |
| 30 | $1,768,000 | $89,000 |
Scenario A ends with $1.77 million. Scenario B nearly runs out of money, despite having the exact same average returns over the period.
The Danger Zone: The First 5-10 Years
Research indicates that investment returns during the first 5-10 years of retirement have an outsized impact on portfolio longevity. This period is sometimes called the "retirement red zone" or "fragile decade."
A severe bear market in the first few years of retirement can permanently impair a portfolio's ability to sustain withdrawals, even if markets recover strongly afterward.
Mitigation Strategy 1: Cash Buffer
Maintain 1-3 years of expenses in cash or short-term bonds. During market downturns, withdraw from this buffer instead of selling depreciated stocks.
| Account | Amount | Purpose |
|---|---|---|
| High-yield savings | $40,000 | Year 1 expenses |
| Short-term Treasury fund | $40,000 | Year 2 expenses |
| Short-term bond fund | $40,000 | Year 3 expenses |
| Total buffer | $120,000 | 3 years of $40,000 withdrawals |
When markets are up, replenish the buffer from investment gains. When markets are down, draw from the buffer and let investments recover.
Mitigation Strategy 2: Flexible Spending
Reduce withdrawals during down markets and increase them during up markets. Even modest flexibility significantly improves portfolio survival rates.
| Market Return (Prior Year) | Spending Adjustment |
|---|---|
| Below -10% | Reduce spending by 10% |
| -10% to 0% | Reduce spending by 5% |
| 0% to +10% | No adjustment |
| Above +10% | May increase spending by 5% |
Worked Example: Flexible Spending
Standard approach: $40,000 per year regardless of market conditions
Flexible approach during a -20% market year:
- Base spending: $40,000
- Reduction: 10%
- Adjusted spending: $36,000
- Savings: $4,000 (remains invested to recover)
This $4,000 left invested during a recovery year (+15%) becomes $4,600, helping to rebuild the portfolio.
Mitigation Strategy 3: Guardrails
The guardrails approach establishes upper and lower spending thresholds based on portfolio performance. When the portfolio hits a guardrail, spending adjusts.
Setup for $1,000,000 portfolio with $40,000 initial withdrawal (4%):
| Guardrail | Withdrawal Rate Trigger | Action |
|---|---|---|
| Upper | Below 3.5% ($40,000 on $1,143,000+) | Increase spending by 10% |
| Lower | Above 5.0% ($40,000 on $800,000 or less) | Decrease spending by 10% |
Example: Portfolio Drops to $800,000
- Current withdrawal rate: $40,000 ÷ $800,000 = 5.0%
- Lower guardrail triggered
- New withdrawal: $40,000 × 90% = $36,000
- New withdrawal rate: $36,000 ÷ $800,000 = 4.5%
The guardrails automatically adjust spending to protect the portfolio during downturns and allow more spending during good times.
Mitigation Strategy 4: Asset Allocation Glide Path
Some retirees reduce stock allocation at retirement, then gradually increase it as retirement progresses. This "rising equity glide path" reduces exposure during the vulnerable early years.
| Retirement Year | Stock Allocation | Bond Allocation |
|---|---|---|
| 0-5 | 40% | 60% |
| 6-10 | 50% | 50% |
| 11-15 | 55% | 45% |
| 16-20 | 60% | 40% |
| 21+ | 60% | 40% |
The lower equity allocation early reduces the impact of early bear markets, while the later increase provides growth potential and inflation protection.
Mitigation Strategy 5: Income Floor
Create a floor of guaranteed income from Social Security, pensions, and annuities that covers essential expenses. Only discretionary expenses depend on portfolio performance.
| Income Source | Monthly Amount | Annual Amount |
|---|---|---|
| Social Security (you) | $2,200 | $26,400 |
| Social Security (spouse) | $1,400 | $16,800 |
| Pension | $800 | $9,600 |
| Guaranteed floor | $4,400 | $52,800 |
If essential expenses are $50,000, the guaranteed floor covers them. Portfolio withdrawals fund only discretionary spending, which can flex with market conditions.
Comparing Mitigation Strategies
| Strategy | Complexity | Effectiveness | Trade-offs |
|---|---|---|---|
| Cash buffer | Low | Moderate | Cash drag on returns in good markets |
| Flexible spending | Low | High | Requires lifestyle flexibility |
| Guardrails | Moderate | High | Requires monitoring and discipline |
| Rising equity glide path | Moderate | Moderate | Lower expected returns early in retirement |
| Income floor | High | High | Annuity costs; less flexibility |
Most retirees benefit from combining multiple strategies rather than relying on one approach.
Sequence Risk Mitigation Checklist
- Calculate your essential vs. discretionary expenses to understand spending flexibility
- Build a cash buffer covering 1-3 years of expenses before retirement
- Establish guardrails or a flexible spending policy before you need it
- Review asset allocation for early retirement years
- Maximize Social Security and pension income to create an income floor
- Delay retirement if facing a bear market immediately before planned retirement date
- Consider delaying Social Security to age 70 to increase guaranteed income
- Stress-test your plan with historical bear market scenarios
- Review and adjust withdrawal strategy annually based on portfolio performance
- Avoid panic selling during market downturns—follow your pre-established plan
- Consider consulting a financial planner for personalized sequence risk analysis