What Is Sequence of Returns Risk? A Guide to Protecting Your Nest Egg Finkerr

Introduction

When you are saving for retirement over your long career, the number you focus on most is the average annual return of your investments. You understand that the market is volatile. There will be good years and bad years. However, you trust that over several decades, the long-term average return will allow your money to grow into a substantial nest egg. For the most part, this is a sound and effective way to think during your saving years.

However, the moment you retire and begin to withdraw money, the rules of the game change dramatically. Suddenly, the average return over your retirement becomes far less important than the order, or the sequence, in which you receive those returns. Experiencing a string of poor market returns in the first few years of your retirement can have a devastating and irreversible impact on how long your money will last. This dangerous phenomenon has a specific name. It is called sequence of returns risk. This guide will clearly define this risk. We will also use a simple example to show its powerful impact and discuss strategies to protect your retirement plan from it.

Defining Sequence of Returns Risk: When the Order Matters Most

First, let’s establish a clear definition. Sequence of returns risk is the danger that the timing and the order of your investment returns during the withdrawal phase of retirement will have a disproportionately negative impact on the long-term survival of your portfolio. This risk is at its absolute highest in the first five to ten years immediately before and after you stop working and begin to rely on your portfolio for income.

Here is the core concept. During your working years, you are in the accumulation phase. You are consistently adding new money to your portfolio from your paychecks. In this phase, the order of returns does not matter very much. A bad year in the market can even be a good thing, as your new contributions are buying assets at a lower price.

However, during your retirement years, you are in the decumulation phase. You are no longer adding money. Instead, you are regularly withdrawing money to live on. If you suffer from poor market returns in the early years of your retirement, you are forced to sell more of your assets at low prices to generate the cash you need. This action permanently depletes your portfolio’s capital base. It leaves you with a much smaller nest egg, which makes it incredibly difficult for your portfolio to recover, even when the market eventually bounces back.

Think of it with this simple analogy.

Imagine you are climbing a tall mountain. During your youth (the accumulation phase), if you slip and slide down 10 feet near the base of the mountain, it is not a big deal. You have plenty of energy and a long time to make up the lost ground.
Now, imagine you have reached the very summit of the mountain and are just beginning your descent (the decumulation phase of retirement). A slip and a 10-foot fall at this point could be catastrophic. You are older, you have less energy to recover, and a fall from the very peak is much more dangerous. A major bear market at the very beginning of your retirement is like slipping right at the summit.

The Devastating Impact: A Tale of Two Retirees

The best way to understand the true danger of this risk is with a clear, numerical example. Let’s look at two hypothetical retirees, Anna and Ben.

Both Anna and Ben have worked hard and have each saved a $1,000,000 portfolio by the time they retire at age 65. They both plan to withdraw $40,000 in their first year of retirement. They will then adjust that amount for inflation each year after. Over the first five years of their retirement, their portfolios experience the exact same average annual return of 5.2%. The only difference between them is the sequence of those returns.

Anna’s Retirement (A Good Sequence)

Anna is lucky. She retires right before a strong bull market.

Year 1: +15% return
Year 2: +12% return
Year 3: +8% return
Year 4: -5% return
Year 5: -10% return Anna’s portfolio gets a very strong start. The early growth provides a large cushion for her withdrawals. The negative years that come later have a much smaller impact on her now-larger portfolio. After five years, her portfolio is still in very healthy shape.

Ben’s Retirement (A Bad Sequence)

Ben is unlucky. He retires right before a major bear market. His returns are the exact reverse of Anna’s.

Year 1: -10% return
Year 2: -5% return
Year 3: +8% return
Year 4: +12% return
Year 5: +15% return Ben is hit with a severe bear market right at the start of his retirement. He is forced to sell his shares at very low prices to fund his first two years of living expenses. This action severely depletes his principal. Even when the good, positive returns finally arrive in years three, four, and five, his portfolio is so much smaller that it struggles to recover. After five years, Ben’s portfolio balance is dramatically lower than Anna’s. His long-term retirement plan is now in serious jeopardy.

This example clearly shows the power of what is sequence of returns risk. Both retirees had the exact same average return. However, because Ben experienced the negative returns at the worst possible time, his portfolio suffered a permanent and potentially devastating blow.

Strategies to Mitigate Sequence of Returns Risk

You cannot control the market’s returns or the order in which they happen. However, you can build a retirement plan that is more resilient to this risk. Here are some practical strategies.

Have a Cash Reserve. One of the most effective strategies is to have one to three years’ worth of your essential living expenses saved in cash or other very safe, liquid accounts, like a high-yield savings account. If a bear market hits in your first few years of retirement, you can live on this cash reserve. This allows you to avoid selling your stocks at low prices. It gives your investment portfolio precious time to recover.
Be Flexible with Your Withdrawals. A withdrawal rule is a great guideline, but it should not be a rigid, unbreakable law. In a year where the market is down significantly, you might choose to temporarily reduce your withdrawal amount. This could mean postponing a large, discretionary expense like a major vacation or a home renovation. This spending flexibility can make a huge difference in your portfolio’s longevity.
Maintain a Balanced Asset Allocation. It is very risky to enter retirement with a portfolio that is 100% in stocks. Holding a healthy allocation of high-quality bonds provides a crucial source of stability. During a stock market crash, your bonds will likely hold their value or may even increase in value. You can then choose to sell your bonds to fund your living expenses. This again allows you to leave your stocks untouched, giving them time to recover.
Use a “Guardrail” Strategy. This is a more dynamic approach to withdrawals. You set a target withdrawal rate, such as 4%. You also set upper and lower “guardrails,” for example, at 5% and 3%. If strong market returns cause your portfolio to grow so much that your withdrawal amount is now less than 3% of the total, you can give yourself a raise. If a market crash causes your withdrawal amount to be more than 5% of your now-smaller portfolio, you make a pre-planned spending cut until the portfolio recovers.

Conclusion

In conclusion, understanding what is sequence of returns risk is one of the most critical and least understood challenges in all of retirement planning. It is the specific danger that a poor sequence of market returns in the early years of your retirement can permanently damage the long-term health and longevity of your portfolio. While the average long-term return is what matters most during your saving years, the specific order of those returns matters immensely when you begin to make withdrawals.

You cannot control the stock market’s returns or the sequence in which they will arrive. You can, however, control your own retirement withdrawal strategy. By building flexibility into your plan, maintaining a cash reserve for down years, and holding a balanced portfolio, you can build a more robust and resilient retirement plan. This thoughtful preparation will help you to protect your hard-earned nest egg from the damaging and irreversible effects of a poorly timed market downturn.