Sequence-of-returns risk

Sequence-of-returns risk is the danger that poor investment returns early in retirement, while you're withdrawing money, permanently damage your portfolio, even if average returns over the whole retirement are fine. It's the main reason withdrawal plans fail, and the main thing early retirees need to plan around.

Why the order of returns matters

While you're saving, the order of returns doesn't change where you end up much. Once you're withdrawing, it matters a great deal. Selling shares after a crash to pay the bills means fewer shares left to recover when markets bounce back.

Consider two retirees who each start with $1,000,000, withdraw $40,000 a year, and get the same returns over two years, just in opposite order:

• Retiree A gets +20% then −20%. After two years: about $890,000.
• Retiree B gets −20% then +20%. After two years: about $874,000.

Same average return, same withdrawals, yet $16,000 apart after just two years, and that gap compounds over the decades that follow. Stretch the bad years into a decade, as in 1966 or 2000, and the difference decides whether the money lasts.

The danger zone

The first five to ten years of retirement carry most of the risk. Historical studies of the 4% rule find that the outcome of a 30-year retirement is largely explained by returns in its first decade. Retirees who started in 1929, 1937, 1966 and 2000 faced the toughest sequences.

How to reduce sequence risk

1. Be flexible with spending. Cutting withdrawals by 10% to 20% after a big decline is the most effective defense. Guardrail strategies formalize this: spend more when the portfolio is well above plan, less when it's well below.
2. Hold a cash or bond buffer. One to three years of spending in cash or short-term bonds lets you avoid selling stocks in a downturn. Many people call this a bucket strategy.
3. Use a lower withdrawal rate. Starting at 3.25% to 3.5% instead of 4% has survived every historical sequence, even over 50 years.
4. Keep some income. Even modest part-time or freelance income in the early years sharply reduces how much you sell during a downturn.
5. Consider a rising equity glide path. Some research suggests starting retirement with more bonds and gradually increasing stocks protects the vulnerable early years.

Does it matter before retirement?

Somewhat. A crash in the last few years before you retire can delay your date. But while you're still contributing, a downturn also lets you buy shares cheaply, which partly offsets the damage.

See how sequence risk plays out for your own plan with the safe withdrawal rate calculator, which simulates thousands of possible market orderings.