What Is Sequence of Returns Risk?
Sequence of returns risk is the risk that poor investment returns occur early in retirement after portfolio withdrawals begin. Because retirees are typically withdrawing money instead of continuing to contribute, the order of investment returns can have a significant effect on how long a retirement portfolio lasts.
Sequence of Returns Risk vs. Average Annual Returns
While these terms are related, they measure different aspects of investment performance. The table below highlights the key differences.
| Category | Sequence of Returns Risk | Average Annual Returns |
|---|---|---|
| Measures | Order of investment returns | Average return over time |
| Most Useful For | Retirement withdrawal impact | Long-term performance |
| Accounts for Timing? | Yes. Timing affects outcomes | No. Timing isn't reflected |
| Retirement Impact | Early losses can shorten portfolio longevity | Same average return, different outcomes |
Average annual returns can help measure long-term performance, but they do not show how the timing of gains and losses may affect a retirement portfolio once withdrawals begin.
Why Timing Matters Once Withdrawals Begin
Once portfolio withdrawals begin, investment returns become path-dependent, meaning the order of gains and losses matters. A market decline early in retirement can have a much greater impact than the same decline years later because withdrawals reduce the amount of money available to recover.
Recovering from a loss also requires a larger percentage gain. For example, a retirement nest egg that falls 20% must gain 25% to return to its previous value. This is why sequence of returns risk becomes more important during retirement than average annual returns alone.
When Sequence of Returns Risk Becomes a Greater Concern
Sequence risk can affect investors at different stages, but it is often a greater concern during periods such as:
- The five years before retirement
- The first 10 years of retirement
- Periods of elevated market volatility
- Extended bear markets
- Rising interest rates and broader economic uncertainty
These years are often called the retirement "red zone" because a market downturn during this period may have a greater effect on retirement savings than it would earlier in an investor's career.
How Sequence of Returns Risk Works
Sequence of returns risk becomes easier to understand when comparing two retirees who earn the same average return but experience market gains and losses in a different order.
Investor A vs. Investor B: Same Average Returns, Different Outcomes
Consider two retirees, Investor A and Investor B. Both begin retirement with a $1 million nest egg, withdraw $50,000 each year, and earn the same average annual return over 20 years.
The only difference is the sequence of their investment returns.
| Category | Investor A | Investor B |
|---|---|---|
| Early Retirement | Market decline | Strong gains |
| Later Retirement | Recovery and growth | Market decline |
| Average Annual Returns | Same | Same |
| Effects of Withdrawals | Withdrawals from a smaller portfolio | Withdrawals from a larger portfolio |
| Retirement Outcome | Lower ending balance | Higher ending balance |
Although both investors earn the same average annual return, their retirement outcomes differ because withdrawals occur at different points across market cycles.
Investor A withdraws money after early losses, while Investor B benefits from early gains that allow the portfolio more time to grow before later market declines.
How Early Market Losses Affect a Retirement Portfolio
Suppose a retiree begins retirement with $1 million and experiences a 25% loss in the first year. The portfolio falls to $750,000 before withdrawals. After taking income, even less capital remains available to participate in a recovery.
Even if the market recovers, the money that was withdrawn during the downturn is no longer invested and cannot participate in the rebound. This may leave the portfolio with a lower ending value than if the same losses had occurred later.
Why Portfolio Withdrawals Can Magnify Losses
During retirement, investors often need to sell investments to generate income. If withdrawals occur during a market downturn, more shares may need to be sold to produce the same dollar amount, leaving fewer investments available to benefit from a future recovery.
Over time, selling investments after market declines can accelerate portfolio depletion and increase the likelihood of exhausting retirement assets sooner than expected.
Why Retirees Are Most Vulnerable to Sequence of Returns Risk
Retirees are especially vulnerable to sequence of returns risk because they rely on their retirement portfolios for income instead of continuing to make contributions. As withdrawals begin, the timing of investment returns can have a greater effect on how long retirement savings last.
How Longer Retirements Increase Sequence of Returns Risk
Longer life expectancy has extended the amount of time many people spend in retirement. As retirement duration increases, portfolios may need to support withdrawals for more years, making early market losses more significant.
The Retirement Red Zone Explained
The retirement red zone refers to roughly the five years before retirement through the first five to ten years afterward. Market declines during this period can have a greater effect because withdrawals are beginning and there is less time to recover.
Market Downturns During Early Retirement
Market downturns are a normal part of investing, but they can be more challenging during retirement because portfolio withdrawals may continue while investment values are falling.
How Market Volatility Can Affect a Retirement Portfolio
Market volatility is generally less concerning while investors are still saving because they have time to recover. During retirement, ongoing withdrawals can magnify the effects of market swings and shorten how long retirement savings last.
Sequence of Returns Risk and Withdrawal Rates
Market performance plays a major role in retirement outcomes, but withdrawal decisions also affect how vulnerable a portfolio is to unfavorable return sequences. Higher withdrawal rates leave less capital invested to recover after a market downturn, increasing sequence of returns risk.
How Withdrawal Rates Affect Portfolio Longevity
A withdrawal rate is the percentage of a retirement portfolio withdrawn each year to cover living expenses.
In general, higher withdrawal rates increase the likelihood that a portfolio will be depleted sooner because more assets are removed during market declines. Lower withdrawal rates leave more of the portfolio invested, allowing more opportunity to recover if markets rebound. For example:
- 3% withdrawal rate: Greater portfolio longevity
- 4% withdrawal rate: Historically sustainable in many scenarios
- 5% or higher withdrawal rate: Greater exposure to sequence of returns risk
Understanding the 4% Rule
The 4% rule is a commonly referenced retirement guideline suggesting that retirees may be able to withdraw approximately 4% of their retirement savings in the first year of retirement and adjust future withdrawals for inflation.
Although it remains widely discussed, actual retirement outcomes can vary based on market conditions, interest rates, life expectancy, and the sequence of investment returns.
How Fixed Withdrawals Can Create Challenges
Withdrawing the same dollar amount during a market downturn reduces the amount of money that remains invested, leaving less capital available to recover when markets rebound.
Strategies to Help Reduce Sequence of Returns Risk
While sequence of returns risk cannot be eliminated, certain investment strategies and retirement income approaches may help reduce its impact during periods of market volatility.
Build an Asset Allocation Strategy for Retirement
Asset allocation plays an important role in managing market risk. A diversified portfolio that includes stocks, fixed income investments, and cash may experience less volatility than one invested primarily in stocks.
Neither asset allocation nor diversification can ensure a profit or protect against losses in declining markets. However, an appropriate asset allocation strategy may help manage risk based on factors such as your age, income needs, risk tolerance, and retirement time horizon.1
Short-term bonds, along with other fixed income investments, can provide stability during periods of stock market weakness. Guaranteed income sources such as Social Security, pensions, and certain annuities can also help cover essential living expenses, reducing the need to withdraw from investment assets during market downturns.
Although fixed income investments carry risks, including interest rate and inflation risk, they may help reduce overall portfolio volatility while providing predictable retirement income.
Adjust Portfolio Withdrawals During Market Declines
Flexible withdrawal strategies may help preserve retirement savings during periods of market volatility. Examples include:
- Reducing discretionary spending
- Delaying large purchases
- Temporarily lowering withdrawal amounts
- Using alternative income sources
Maintain Cash Reserves for Short-Term Spending Needs
Many retirees keep one to three years of anticipated spending in cash or other highly liquid accounts. This may reduce the need to sell investments during a market decline, giving the remaining assets more time to recover.
Consider Delaying Retirement or Working Longer
Working one or two additional years may strengthen retirement readiness by allowing more time to save, delaying portfolio withdrawals, and extending the period before retirement income is needed.
Common Misconceptions About Sequence of Returns Risk
Several misconceptions continue to circulate about sequence of returns risk.
Average Returns Tell the Whole Story
This myth overlooks the importance of timing. Two portfolios with identical average returns can produce very different retirement outcomes when portfolio withdrawals are involved. Once withdrawals begin, the order of investment returns can be just as important as the average return itself.
Sequence of Returns Risk Only Matters After Retirement
Sequence risk can begin before retirement. Significant market declines in the years leading up to retirement may reduce portfolio values before withdrawals even begin. This is one reason the years immediately before retirement are often considered part of the retirement red zone.
Market Recoveries Always Fix Early Losses
Markets often recover, but retirement portfolios do not always recover equally. When withdrawals occur during market downturns, the money removed from the portfolio no longer participates in future gains, which can have lasting effects even after markets rebound.
Conclusion
Sequence of returns risk shows why the timing of investment returns matters during retirement. Early market declines combined with portfolio withdrawals can have lasting effects on retirement savings, even when long-term average returns are similar. Understanding this risk can help investors better evaluate their retirement plans.
Sources
- Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing. https://www.investor.gov/additional-resources/general-resources/publications-research/info-sheets/beginners-guide-asset
