What Is Sequence of Returns Risk? Why It Matters in Retirement

Imagine two retirees who have exactly the same amount of money, exactly the same average investment return and exactly the same retirement spending.

One runs out of money much earlier than the other.

How is that possible?

One reason is sequence of returns risk.

The order in which investment returns occur can matter enormously when you are withdrawing money from your portfolio. Two portfolios can experience the same long-term average return while producing very different retirement outcomes.

This is particularly important during the first several years of retirement, when withdrawals are reducing the portfolio at the same time that investments are experiencing market gains or losses.

Understanding sequence of returns risk can help explain why a retirement plan should be more than a simple calculation based on an expected average return.

What Is Sequence of Returns Risk?

Sequence of returns risk is the risk that the order in which investment returns occur will negatively affect your retirement outcome.

During your working years, a major market decline can be painful, but you may have many years to recover. You may also be contributing new money to your investments.

During retirement, the situation can be very different.

If your portfolio falls significantly soon after retirement and you continue withdrawing money to pay your expenses, you are selling from a smaller portfolio after it has declined.

That can leave fewer assets available to participate in a future recovery.

This is the basic problem created by sequence of returns risk.

A Simple Example

Consider two hypothetical portfolios.

Both investors retire with $1 million. Both withdraw money from their portfolios during retirement. Both portfolios eventually experience the same set of annual investment returns.

The difference is the order of those returns.

Investor A experiences several strong years at the beginning of retirement followed by weaker years.

Investor B experiences several poor years at the beginning followed by strong years.

Even if the average return over the entire period is identical, the two investors can end up with very different portfolio balances.

Why?

Investor B is withdrawing money while the portfolio is falling. Those withdrawals can permanently reduce the amount of capital available to recover when markets eventually improve.

The mathematics of compounding means that the order of returns matters when withdrawals are occurring.

Why Average Investment Returns Can Be Misleading

Retirement projections often use an assumed average investment return.

For example, someone might assume their portfolio will earn an average of 6% per year over retirement.

But a 6% average return does not mean the portfolio will earn 6% every year.

Real investment returns can vary significantly from year to year. You could experience several positive years, followed by a major decline, followed by several years of recovery.

Or the sequence could happen in the opposite order.

This is why a retirement plan based only on an average return can give a false sense of precision.

The average matters, but the path matters too.

Why Sequence Risk Is Especially Important at Retirement

Sequence of returns risk is most concerning when you are taking withdrawals from your investments.

Before retirement, you are generally adding money to your portfolio. A market decline may allow you to purchase additional investments at lower prices.

After retirement, you are generally doing the opposite.

You are taking money out.

If markets decline substantially, you may be selling investments while their values are lower.

This can make a poor sequence of returns particularly damaging.

Sequence Risk and the 4% Rule

Sequence of returns risk is one of the reasons the 4% rule became such an important concept in retirement planning.

Withdrawal-rate research is designed in part to examine whether a portfolio can survive different combinations of market returns, inflation and withdrawals.

But the 4% rule is not a guarantee, and it is not a personalized retirement plan.

Your actual situation may be very different from the historical scenarios used to develop a particular withdrawal-rate strategy.

Your retirement could last longer or shorter than the period modeled. Your spending may change. Your investment portfolio may differ. You may have pensions or government benefits. Taxes may affect your withdrawals. You may be willing to reduce spending after a major market decline.

Sequence risk is one reason it is useful to test your own numbers rather than relying entirely on a single withdrawal rule.

Sequence Risk Does Not Mean Market Crashes Are Always Fatal

It is important not to overstate sequence of returns risk.

A market decline early in retirement does not automatically mean that your retirement plan will fail.

The impact depends on many factors, including:

• Portfolio size
• Withdrawal amount
• Withdrawal rate
• Investment allocation
• Other sources of income
• Retirement spending
• Taxes
• Inflation
• Length of retirement
• Ability to adjust spending
• Future investment returns

Someone with a large portfolio and substantial pension income may be much less affected by an early market decline than someone whose portfolio must fund nearly all of their retirement spending.

Reliable Income Can Reduce Sequence Risk

One of the most important factors in retirement planning is the amount of spending that does not have to come directly from your investment portfolio.

Depending on your circumstances, this might include:

• Defined benefit pensions
• Social Security
• CPP
• OAS
• Rental income
• Part-time employment
• Other relatively reliable income sources

If these sources cover a substantial portion of your essential expenses, your portfolio may not need to provide as much income during a market downturn.

That can give you more flexibility when markets are weak.

Our article CPP, OAS and Social Security: How Government Benefits Affect Retirement Planning explores how government benefits fit into the larger retirement picture.

Spending Flexibility Can Also Help

Another potential way to manage sequence risk is to recognize that retirement spending does not always have to remain fixed.

Suppose your portfolio experiences a significant decline shortly after you retire.

If your retirement plan allows you to temporarily reduce discretionary spending, you may be able to reduce the amount you need to withdraw while your portfolio is under pressure.

This is very different from assuming that every retiree must spend exactly the same amount every year regardless of market conditions.

Spending flexibility can therefore become another tool for managing retirement risk.

Of course, not all expenses are flexible. Housing, food, healthcare, taxes and other essential expenses may not be easily reduced.

The important question is how much of your retirement spending is flexible if circumstances change.

Why the First Years of Retirement Matter

Sequence risk is often associated with the early years of retirement because the portfolio has not yet had many years to grow after withdrawals begin.

Imagine retiring just before a significant market decline.

Your portfolio falls, but your retirement spending does not automatically stop. You continue taking withdrawals while the portfolio is worth less.

If markets subsequently recover, the portfolio is recovering from a smaller base.

Now compare that with someone who retires just before several strong market years. Their portfolio may grow before withdrawals become a larger percentage of the remaining assets.

This is why two retirees with identical starting balances and identical long-term average returns can have different results.

Can You Predict the Sequence of Returns?

No one knows exactly what investment returns will occur over the next 20 or 30 years.

That means the solution to sequence risk is not trying to predict the perfect year to retire or accurately forecast the next market crash.

A better approach is to build a retirement plan that can withstand a reasonable range of possible outcomes.

This is where scenario analysis and retirement simulations can be useful.

Monte Carlo Simulations and Sequence Risk

A Monte Carlo retirement simulation can test a retirement plan against many different possible sequences of investment returns.

Instead of assuming that your portfolio earns the same return every year, a simulation can expose the plan to different combinations of returns and other assumptions.

This can reveal an important distinction:

A retirement plan may work under its average assumptions but struggle under an unfavorable sequence of returns.

Monte Carlo analysis is not a prediction of what will happen. It is a way of exploring how a plan responds to many possible outcomes.

Sequence Risk and Retirement What-If Scenarios

Sequence risk is also a good reason to create retirement What-If scenarios .

You can ask:

• What if I retire two years later?
• What if I retire two years earlier?
• What if investment returns are lower?
• What if inflation is higher?
• What if I reduce spending during a market downturn?
• What if I delay government benefits?
• What if I have additional income?
• What if I live longer than expected?

These scenarios help move retirement planning away from the question of "What will happen?" and toward the more useful question of "How does my plan respond if things turn out differently?"

Asset Allocation and Sequence Risk

Asset allocation can also affect how a portfolio responds to a sequence of returns.

A portfolio invested entirely in assets with substantial market volatility may experience larger short-term fluctuations than a more diversified portfolio with assets that behave differently.

On the other hand, moving entirely into very conservative investments can introduce other risks, including inflation and the possibility that the portfolio does not grow enough to support a long retirement.

There is therefore no single asset allocation that eliminates every retirement risk.

Asset allocation should be considered alongside spending, income, taxes, account types, retirement age and the length of the retirement plan.

Sequence Risk Is Different From Investment Risk

Investment risk and sequence of returns risk are related, but they are not exactly the same thing.

Investment risk is the possibility that an investment loses value or performs differently than expected.

Sequence risk is specifically concerned with how the timing and order of those returns interact with withdrawals.

A major decline before retirement can be painful. A similar decline early in retirement can have a very different effect because the investor is simultaneously taking money out of the portfolio.

Taxes Can Make Sequence Risk More Complicated

Taxes can add another layer to the problem.

The amount you need to withdraw from an account is not necessarily the amount you get to spend.

Depending on the account and your circumstances, withdrawals may create taxable income.

This means a retirement plan should consider not only investment returns and withdrawals, but also the tax consequences of those withdrawals.

Our article How to Create a Tax-Efficient Retirement Income Plan explains why withdrawal sequencing and account selection can affect after-tax retirement income.

What Can You Do About Sequence of Returns Risk?

You cannot eliminate sequence risk completely, but you can build a retirement plan that is designed to deal with uncertainty.

Consider these approaches:

1. Build a realistic retirement budget. Know how much income your retirement actually requires.
2. Identify reliable income. Understand how much of your essential spending can be covered without relying entirely on investments.
3. Understand your withdrawal rate. Know what percentage of your portfolio you expect to withdraw and how that changes over time.
4. Maintain spending flexibility. Identify which expenses could be reduced if markets perform poorly.
5. Consider taxes. Understand how withdrawals from different accounts affect taxable income.
6. Test different return sequences. Do not rely exclusively on one average investment return.
7. Stress-test the retirement plan. Explore what happens under unfavorable assumptions.
8. Review the plan regularly. Retirement planning is not something you complete once and never revisit.

Sequence Risk Is One Reason Retirement Planning Should Be Personal

A retirement rule can be useful as a starting point, but your retirement is not a historical average.

Your spending is different. Your income is different. Your account balances are different. Your taxes are different. Your retirement date is different. Your expected longevity is different.

Most importantly, your ability to adjust your decisions may be different.

Someone with substantial pension income and flexible discretionary spending may have a very different level of sequence risk from someone who depends almost entirely on portfolio withdrawals.

This is why personalized retirement planning can be much more useful than simply asking whether your portfolio equals a particular multiple of your annual spending.

How Retirementize Can Help You Test Sequence Risk

Retirementize is designed to help you look at the entire retirement picture rather than focusing on one number.

You can build a retirement plan that includes your savings, investments, pensions, government benefits, spending, housing, taxes and other important assumptions.

You can then change assumptions and test different retirement decisions.

This is particularly useful for sequence risk because you can explore how your plan responds to different investment outcomes rather than assuming that markets will follow one predictable path.

Retirementize also allows you to examine different retirement scenarios, including changes to retirement timing, spending, longevity and other major decisions.

The goal is not to predict the future.

The goal is to understand how resilient your plan may be if the future does not unfold exactly as expected.

PLAN. IMPROVE. TEST. CONFIRM. REPEAT.

Sequence of returns risk is a perfect example of why retirement planning should be an ongoing process.

PLAN. Build your retirement plan using realistic income, spending, investment and tax assumptions.

IMPROVE. Look for ways to strengthen the plan through savings, spending, income, retirement timing and other decisions.

TEST. Examine what happens when investment returns, inflation, longevity or spending are different from your original assumptions.

CONFIRM. Determine whether the plan remains capable of supporting your goals under a reasonable range of outcomes.

REPEAT. Revisit the plan as your circumstances and the world around you change.

This approach is much more useful than assuming that one average investment return tells you what your retirement will look like.

Sequence of Returns Risk: Frequently Asked Questions

What is the biggest danger of sequence of returns risk?

The biggest concern is generally experiencing significant investment losses early in retirement while simultaneously withdrawing money. This can reduce the amount of capital available to participate in a future recovery.

Does sequence of returns risk matter before retirement?

It can, but it is generally more significant once withdrawals begin. Before retirement, investors may have time to recover and may still be contributing to their portfolios.

Can sequence of returns risk be eliminated?

No. Investment returns are uncertain. However, a well-designed retirement plan can include strategies and flexibility that may reduce the impact of unfavorable return sequences.

Does the 4% rule eliminate sequence risk?

No. Sequence of returns risk is one of the risks that withdrawal-rate research attempts to address, but no withdrawal rule guarantees that a particular retirement portfolio will succeed.

Does Monte Carlo eliminate sequence risk?

No. Monte Carlo simulation does not predict or eliminate sequence risk. It can help illustrate how a retirement plan behaves across many different possible sequences of returns.

Should I delay retirement because of sequence risk?

Not necessarily. Delaying retirement is one possible way to change the mathematics of a retirement plan, but it is only one option. Spending, savings, investment allocation, government benefit timing, income and other factors can also affect the plan.

Fun Facts About Sequence of Returns Risk

Related Retirement Planning Articles

Sequence of returns risk connects to many of the other topics in our retirement planning series.

• The NEW 4% Rule: Why You May Be Able to Spend More in Retirement
• How to Create a Tax-Efficient Retirement Income Plan
• Test Your Retirement Plan
• What Is a Monte Carlo Retirement Simulation?
• Retirement What-If Scenarios
• How to Stress-Test Your Retirement Plan
• How Do I Know If My Retirement Plan Is on Track?

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