Sequence of returns risk is a critical concept for retirees and soon-to-be retirees managing their investment withdrawals. Unlike traditional focus solely on average portfolio returns, this risk emphasizes the order in which you experience gains and losses, which greatly affects how long your retirement savings last.
How Sequence of Returns Risk Works
Imagine retiring with $1 million and planning to withdraw $40,000 annually adjusted for inflation. If the market suffers negative returns in the initial years, your portfolio shrinks significantly, but you must continue withdrawing the same or increasing amounts. Since the base is smaller, those withdrawals consume a larger portion of your funds.
When the market eventually recovers, the investment gains are on a smaller principal, limiting growth potential. This sequence can cause your savings to be exhausted earlier than if positive returns had occurred first. Conversely, if your early retirement years yield strong returns, your portfolio grows, providing more buffer against later downturns.
Historical Context and Importance
The recognition of sequence of returns risk became prominent after market downturns like the dot-com bubble burst in 2000 and the 2008 financial crisis devastated many retirees’ savings. Financial planners realized that retirees with identical average returns but differing sequences of returns had vastly different retirement outcomes.
Understanding this risk is now fundamental to retirement planning and income strategy.
Who Is Most Affected?
- Retirees and Near-Retirees: Those drawing down investments rely on steady portfolio withdrawals and feel the impact the most.
- Investors With Fixed Withdrawal Amounts: Without flexibility, fixed withdrawals can accelerate depletion during market slumps.
- People Without Diversified Portfolios: Lack of asset diversification increases vulnerability to volatility.
Key Strategies for Managing Sequence of Returns Risk
- Diversification: Allocating investments across stocks, bonds, and cash can smooth volatility and reduce portfolio swings.
- Cash Reserves: Keeping 1-3 years’ worth of expenses in liquid, safe accounts helps avoid selling investments in down markets.
- Flexible Withdrawal Plans: Reducing withdrawals during negative market years can preserve capital.
- Annuities for Guaranteed Income: Incorporating annuities provides a steady income floor regardless of market performance.
- Bucket Strategy: Segmenting investments into short-, medium-, and long-term buckets aligns liquidity needs with growth investments.
- Delaying Retirement or Withdrawals: Working longer or postponing withdrawals allows more time for portfolio recovery.
- Regular Portfolio Rebalancing: Keeping asset allocations aligned with risk tolerance and retirement goals maintains stability.
Understanding Withdrawal Rates
Most financial experts recommend starting with a withdrawal rate between 3% and 4% annually, adjusted for inflation, to reduce longevity risk and sequence risk. The often cited “4% rule” is a guideline, but flexibility is critical.
Example Illustration
Consider two retirees each with a $1 million portfolio withdrawing $40,000 annually:
| Year | Portfolio Value (Good Early Returns) | Portfolio Value (Bad Early Returns) | Annual Withdrawal | Market Return (%) |
|---|---|---|---|---|
| 0 | $1,000,000 | $1,000,000 | – | – |
| 1 | $1,100,000 | $900,000 | $40,000 | 10% / -10% |
| 2 | $1,210,000 | $765,000 | $40,000 | 10% / -15% |
| 3 | $1,331,000 | $718,500 | $40,000 | 10% / 5% |
The retiree facing early bad returns sees a much faster depletion of assets despite the same average market return.
Common Misconceptions
- Focusing only on average returns: Ignoring return sequence underestimates withdrawal risks.
- Fixed withdrawals during all market cycles: Not adjusting spending during downturns can deplete savings prematurely.
- Believing bonds eliminate the risk: While bonds reduce volatility, they cannot eliminate sequence risk entirely.
When to Monitor and Adjust
Review your withdrawal strategy annually or after significant market movements. Adjust your spending, portfolio allocations, or explore guaranteed income options to mitigate risks.
Additional Resources
For in-depth retirement strategies, visit our Retirement Planning and Retirement Income Strategies pages.
For safe withdrawal planning and tax implications, see IRS guidelines on Required Minimum Distributions (RMD) and consult ConsumerFinance.gov’s retirement tips.
Conclusion
Sequence of returns risk is a vital consideration in retirement financial planning. By understanding how the timing of returns interacts with withdrawal patterns and using well-known strategies to manage the risk, retirees can improve the chances their savings will last through retirement.
References
- Morningstar: Sequence of Returns Risk Essentials
- IRS Publication on Retirement Withdrawal Tax Implications (IRS.gov)
- Consumer Financial Protection Bureau: Retirement Planning Guides
- Investopedia: Sequence of Returns Risk
- Forbes: Managing Sequence of Returns Risk in Retirement