Most investors understand that market volatility is part of investing, but there’s a hidden danger that can devastate retirement portfolios even when long-term returns meet expectations.
It’s called sequence of returns risk, and it’s one of the most misunderstood threats to retirement security. This silent wealth killer can turn a well-funded retirement plan into a financial disaster, regardless of how well you saved or how reasonable your withdrawal strategy seemed.
Understanding sequence of returns risk is crucial for anyone approaching or in retirement. Unlike the accumulation phase of your career when you have time to recover from market downturns, retirement planning strategies during poor market performance require careful consideration to avoid a downward spiral that’s impossible to reverse.
What Is Sequence of Returns Risk?
Sequence of returns risk is the danger that poor investment returns early in retirement, combined with ongoing withdrawals, can permanently damage your portfolio’s ability to sustain your retirement income. It’s not just about having bad years – it’s about when those bad years occur.
During your working years, the order of returns doesn’t matter much. Whether you experience a 20% loss in year one followed by a 25% gain in year two, or the reverse, your final balance will be the same if you’re not making withdrawals. However, once you start taking money out of your portfolio through systematic withdrawal plans, the sequence becomes critical.
Poor returns early in retirement force you to sell more shares to meet your withdrawal needs, leaving fewer shares to participate in any subsequent market recovery. This creates a mathematical problem that can’t be solved by simply waiting for better returns.
Why Timing Matters More Than Average Returns
Consider two retirees who both experience the same average annual return over 20 years, but in different sequences:
Retiree A experiences poor returns in the first few years of retirement, followed by strong returns. Retiree B experiences strong returns early in retirement, followed by poor returns later.
Even though both retirees experience identical average returns over the full period, Retiree A’s portfolio may be completely exhausted while Retiree B still has substantial assets remaining. This counterintuitive outcome occurs because early losses, combined with withdrawals, reduce the base from which future gains can compound. This is why portfolio diversification strategies become even more critical as you approach retirement.
The Mathematics of Sequence Risk
The math behind sequence of returns risk is straightforward but powerful. When your portfolio loses value and you continue taking withdrawals, you’re forced to sell a larger percentage of your remaining assets. These sold assets can’t participate in future market recoveries.
For example, if your $1 million portfolio drops 20% in year one, you’re left with $800,000. If you need to withdraw $40,000 for living expenses, you’re now taking 5% of your remaining portfolio instead of the planned 4%. This higher withdrawal rate, combined with the reduced asset base, makes it increasingly difficult for your portfolio to recover.
The situation becomes even more dire if poor returns continue for several years. Each year of negative returns combined with withdrawals accelerates the depletion of your portfolio, creating what financial planners call the “sequence of returns death spiral.”
Real-World Examples That Illustrate the Risk
The 2000-2002 dot-com crash and the 2008 financial crisis provide stark examples of sequence risk in action. Retirees who began withdrawing from their portfolios just before these market downturns faced devastating consequences, even though markets eventually recovered.
Consider someone who retired in 2000 with a $1 million portfolio and planned to withdraw 4% annually, adjusting for inflation. After the three-year bear market from 2000-2002, many of these retirees found their portfolios reduced by 40-50%, despite following conventional wisdom about safe withdrawal rates.
Even more concerning, many of these portfolios never recovered to their original value, despite the strong bull markets that followed. The early losses, combined with ongoing withdrawals, created a permanent reduction in their retirement security.
Protecting Yourself from Sequence Risk
Fortunately, there are several strategies to protect your retirement from sequence of returns risk:
1. Build a Cash Buffer
Maintain 1-3 years of living expenses in cash or short-term bonds. This buffer allows you to avoid selling investments during market downturns, giving your portfolio time to recover. While cash doesn’t grow, it provides crucial flexibility during volatile periods. Learn more about building an effective emergency fund for retirees.
2. Use a Bond Ladder or Bond Tent
As you approach retirement, gradually shift a portion of your portfolio to bonds or other fixed-income investments. This “bond tent” approach reduces your overall portfolio volatility just when sequence risk is most dangerous. Consider building a bond ladder strategy that matures over your first 5-10 years of retirement.
3. Implement Dynamic Withdrawal Strategies
Instead of rigidly withdrawing the same percentage each year, adjust your withdrawals based on market performance. In poor market years, reduce your withdrawals if possible. In strong market years, you might take slightly more. This flexibility can significantly extend your portfolio’s longevity.
4. Consider Guaranteed Income Sources
Annuities, despite their complexity and fees, can provide a floor of guaranteed income that isn’t subject to sequence risk. Social Security serves a similar function. Having some guaranteed income reduces the pressure on your investment portfolio and provides peace of mind. Explore our guide to retirement income annuities to understand your options.
5. Plan for Flexibility in Retirement Spending
Build flexibility into your retirement by distinguishing between essential expenses and discretionary spending. If markets perform poorly early in retirement, you can reduce discretionary expenses without compromising your basic needs. A retirement calculator can help you plan for various scenarios.
The Importance of Professional Guidance
Sequence of returns risk is complex and highly personal. The right strategy depends on your specific financial situation, risk tolerance, and retirement goals. Working with a fee-only financial advisor who understands this risk can help you develop a comprehensive strategy that protects your retirement while still allowing for growth.
Your advisor should stress-test your retirement plan using various market scenarios, including sequences of poor returns early in retirement. This analysis will help you understand your portfolio’s vulnerabilities and develop appropriate safeguards.
Taking Action Before It’s Too Late
The best time to address sequence of returns risk is before you retire, when you still have time to adjust your savings rate, investment allocation, or retirement timeline. However, even if you’re already retired, there are steps you can take to protect your portfolio.
Remember, sequence of returns risk isn’t just about market volatility – it’s about the interaction between market timing and your withdrawal needs. By understanding this risk and implementing appropriate strategies, you can significantly improve the odds of your retirement portfolio lasting throughout your lifetime.
The key is recognizing that retirement investing is fundamentally different from accumulation-phase investing. The strategies that served you well during your working years may not be appropriate once you begin relying on your portfolio for income. Taking proactive steps to address sequence risk can mean the difference between a comfortable retirement and one filled with financial stress.
About the Financial Planning Author
Alexander Langan, J.D, CFBS, serves as the Chief Investment Officer at Langan Financial Group. In this role, he manages investment portfolios, acts as a fiduciary for group retirement plans, and consults with clients regarding their financial goals, risk tolerance, and asset allocation.
With a focus on ERISA Law, Alex graduated cum laude from Widener Commonwealth Law School. He then clerked for the Supreme Court of Pennsylvania and worked in the Legal Office of the Pennsylvania Office of the Budget, where he assisted in directing and advising policy determinations on state and federal tax, administrative law, and contractual issues.
Alex is also passionate about giving back to the community, and has participated in The Foundation of Enhancing Communities’ Emerging Philanthropist Program, volunteers at his church, and serves as a board member of Samara: The Center of Individual & Family Growth. Outside of work and volunteering, Alex enjoys his time with his wife Sarah, and their three children, Rory, Patrick, and Ava.
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Please consult legal or tax professionals for specific information regarding your individual situation.
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