Sequence of Returns Risk

Key Takeaways

• Sequence of returns risk describes how the order of investment returns, especially early in retirement, can significantly impact the longevity of a portfolio.
• Early market losses during the withdrawal phase can reduce future income potential, even if long-term average returns are favorable.
• Portfolio withdrawals during downturns compound losses, leaving less capital to recover when markets rebound.
• Diversification and asset allocation strategies help manage volatility and reduce exposure to sequence risk.
• Retirement income planning should include strategies to minimize withdrawals during market declines, such as maintaining a cash reserve or flexible withdrawal policy.
• Safe withdrawal rates and dynamic spending rules can help preserve portfolio value through different market conditions.
• Annuities and guaranteed income products can provide steady payments that protect retirees from running out of money during prolonged downturns.
• Dollar-cost averaging during the accumulation phase helps reduce the impact of market volatility on long-term investment growth.
• Monte Carlo simulations and other forecasting tools are often used by financial planners to evaluate how sequence risk may affect future retirement outcomes.
• Economic approaches to retirement planning emphasize consumption smoothing and spending only from safe assets like Treasury Inflation-Protected Securities, while treating growth investments as unavailable until converted, which can eliminate sequence risk during the accumulation period and establish a protected living standard floor with upside potential.
• Understanding sequence of returns risk is essential for building a sustainable retirement strategy that balances income needs, risk tolerance, and long-term growth potential.

What Is the Sequence of Returns Risk?

Sequence of returns risk refers to the possibility that the timing of investment gains and losses will impact portfolio performance especially when investors are making withdrawals. While the average annual return over a long period might appear stable, poor returns early in retirement can severely reduce the total value of savings. This happens because withdrawing funds during market declines leaves less capital to benefit from later recoveries. Over time, this can shorten how long a portfolio lasts, even if average returns match those of someone who experienced losses later instead of sooner.

The mechanics of sequence risk are rooted in compounding and withdrawal timing. When a retiree draws income from their portfolio during a downturn, they are forced to sell more shares or assets to meet their income needs. Those sold assets no longer participate in future rebounds, reducing the base for future growth. Conversely, experiencing strong returns early in retirement can have the opposite effect, allowing the portfolio to compound on a larger base and support higher lifetime withdrawals.

Several factors influence the severity of sequence risk, including market volatility, withdrawal rate, asset allocation, and inflation. Investors with higher equity exposure face greater short-term volatility, while those holding more bonds may preserve capital but risk underperformance against inflation. Balancing these factors requires careful planning and diversification across asset classes to cushion early losses. Financial planners often use strategies such as cash buckets, bond ladders, or partial annuitization to create a buffer against adverse market timing.

Understanding the sequence of returns risk is crucial for anyone approaching or already in retirement. It emphasizes that investment success isn't just about achieving a target return, it's about when those returns occur. Concepts like safe withdrawal rates, retirement glide paths, and Monte Carlo simulations are often used to model different market sequences and guide income strategies. Some economic approaches to retirement planning emphasize consumption smoothing within a lifetime budget constraint rather than focusing solely on static withdrawal rates, recognizing that sustainable living standards depend on coordinating spending decisions with available resources across the entire retirement period. By planning for variability rather than assuming average performance, retirees can protect their savings and maintain steady income even through volatile markets.

How Sequence of Returns Risk Works

The Timing Effect on Portfolio Withdrawals

Sequence of returns risk primarily affects retirees or anyone drawing regular income from investments. When markets decline early in retirement, each withdrawal reduces not only the portfolio balance but also the amount left to recover once the market rebounds. This means the same average annual return can lead to drastically different outcomes depending on when gains and losses occur. A 20% market drop early on can take years to recover if withdrawals continue during that period. Historical simulations and practitioner analyses indicate that many portfolio failures involve significant losses early in retirement, highlighting the critical importance of managing withdrawals during the first few years. While the broader "retirement risk zone" (spanning roughly 5-10 years before and 5-10 years after retirement begins) encompasses the transition into retirement, the first five years represent the period of highest vulnerability when portfolios are typically at their largest and most exposed to market volatility. During the accumulation phase when investors are still saving, sequence of returns risk has minimal impact because contributions continue regardless of market conditions and there are no withdrawals reducing the capital base.

Step-by-Step: How Sequence Risk Impacts a Portfolio

1. Investment Accumulation Phase - During the saving years, the order of returns does not significantly matter because no withdrawals are made. All returns, positive or negative, are reinvested, and the portfolio continues to compound.
2. Transition to Retirement - Once withdrawals begin, the sequence of returns starts to matter. A portfolio hit by negative returns early in retirement experiences greater long-term damage than one with similar losses later.
3. Withdrawal During Market Downturn - The retiree must sell more assets to maintain the same income. This locks in losses and reduces the remaining capital available to grow.
4. Reduced Recovery Potential - With fewer assets left to compound, the portfolio struggles to recover when markets improve, leading to a higher risk of depletion.
5. Long-Term Outcome - Over a 20- or 30-year retirement horizon, the portfolio that faced early losses will often run out of money years earlier than one that experienced the same losses later.

Factors That Magnify or Reduce Sequence Risk

Several factors can either increase or reduce the impact of sequence risk:

• Withdrawal Rate: Higher withdrawal percentages amplify losses because more capital is removed during downturns.
• Asset Allocation: Portfolios heavily weighted in equities face higher volatility, while bond-heavy portfolios may experience lower growth.
• Market Volatility: Greater fluctuations in returns heighten sequence risk, particularly during the first decade of retirement.
• Inflation: Rising prices may force higher withdrawals, accelerating portfolio decline.
• Flexibility in Spending: Reducing withdrawals during poor market years can significantly extend portfolio longevity.

Managing Sequence of Returns Risk

To mitigate sequence risk, financial planners employ various retirement income strategies:

• Diversification: Holding a mix of asset classes (stocks, bonds, and cash) helps stabilize returns.
• Cash Reserve or Bucket Strategy: Keeping 1-3 years of living expenses in cash or short-term bonds prevents forced selling during downturns.
• Dynamic Withdrawal Rules: Adjusting spending based on market performance (for example, cutting withdrawals during poor years) helps preserve capital.
• Annuities or Guaranteed Income: Converting part of savings into guaranteed income streams reduces reliance on market-dependent withdrawals.
• Glide Path Adjustments: Gradually reducing stock exposure before and during retirement can soften the impact of market volatility.

Alternative approaches discussed in economic literature focus on separating safe assets from growth assets for spending purposes. Under these frameworks, households may spend only from secure income sources such as Treasury Inflation-Protected Securities (TIPS) while treating stock investments as unavailable until converted to safe assets. This upside investing methodology can eliminate sequence risk during the accumulation period by allowing stocks to grow undisturbed, with the living standard floor rising only when growth assets are converted. Comprehensive financial planning software like MaxiFi can model these consumption smoothing strategies, showing both protected living standard floors and potential upsides based on different allocation decisions.

Understanding how sequence of returns risk works highlights the importance of not just what investments earn, but when those earnings occur. Proper planning, diversified portfolios, and flexible income strategies are key to protecting retirement savings against the unpredictable order of market returns.

Asset Class Sensitivity and Real-World Examples

After understanding how sequence of returns risk develops, it's important to see how it behaves across different types of investments and real-life scenarios. Not all asset classes respond to market fluctuations in the same way. Some amplify risk, while others help cushion the impact of early losses. Recognizing these differences helps investors design portfolios that remain resilient even when returns occur in an unfavorable order.

Asset Class Sensitivity to Sequence of Returns Risk

Each major asset class contributes differently to a portfolio's exposure to sequence risk:

• Equities (Stocks): Because stock prices can fluctuate sharply, large market declines early in retirement can reduce the portfolio's value just as withdrawals begin. Selling shares during downturns locks in losses, leaving fewer assets to recover when markets rebound.
• Fixed Income (Bonds): Bonds generally offer stability and steady income, but they are sensitive to interest-rate changes. Rising rates can cause bond prices to fall, reducing their market value. Shorter-term bonds or laddered maturities can limit this impact.
• Cash and Cash Equivalents: Holding some cash provides liquidity and helps retirees avoid selling investments during downturns. However, excessive cash holdings may erode purchasing power over time because of inflation.
• Real Estate and Alternatives: Assets such as real estate, commodities, or private investments can diversify returns but often have lower liquidity. If markets decline and withdrawals are needed, selling these assets quickly may result in losses.

A thoughtful mix of growth assets (equities) and defensive assets (bonds, cash) helps balance risk and return. Maintaining this asset allocation through regular rebalancing reduces the likelihood that early negative returns will permanently derail long-term goals.

Illustrative Example: The Timing Trap

Consider two retirees, Alex and Jamie, each beginning retirement with $1 million and withdrawing $40,000 annually. Both experience identical returns totaling 0% over five years (average of 0% per year) - but in reverse order.

Illustrative Example: The Timing Trap

Note: Portfolio values shown are after annual withdrawals of $40,000. Returns are applied before withdrawals are taken at year-end. 

Despite identical average returns of 0%, sequence matters dramatically. After five years, Alex's portfolio ($804,843) exceeds Jamie's ($759,002) by $45,841 - nearly 6% more wealth preserved. Alex's early gains (+12%, +8%) build substantial portfolio value before losses occur, while Jamie's early losses (-9%, -8%) permanently reduce the base that later gains can compound from. By Year 2, Jamie has already fallen behind by $366,000, and even strong final returns (+8%, +12%) cannot fully recover the lost ground. When withdrawing during retirement, positive returns early in the sequence protect significantly more wealth than identical returns arriving later. This is sequence-of-returns risk: the order of returns can create a $45,841 difference in outcomes even when total returns are identical.

Integrating Asset Behavior With Broader Retirement Planning

Understanding the interaction between asset performance and withdrawal timing helps retirees coordinate investment, income, and risk management decisions. Investors can:

• Maintain diversified portfolios to reduce exposure to single-asset volatility
• Use cash reserves or short-term bonds to fund spending during down markets
• Rebalance periodically to restore target allocations after market swings
• Plan withdrawals flexibly, increasing or reducing them based on performance

By aligning asset allocation with spending needs, investors transform an unpredictable sequence of returns into a managed financial strategy. This integration of portfolio design, withdrawal timing, and behavioral discipline is the most effective defense against sequence-related losses.