Sequence Risk
Early Retirement,  Finances,  Investing

Sequence of Returns Risk and the Danger of Retiring at the Wrong Time

Sequence of Returns Risk

One of the biggest challenges that may impact the success of any retirement plan is called sequence of returns risk, or sequence risk.

In essence, sequence of returns risk is the risk that comes with the order in which your returns occur. If the first few years of your retirement plan are impacted by negative returns then the success rates of said plan can drop precipitously. It is a significant threat to any retiree and needs to be understood and accounted for within your retirement planning.

Remember, when you’re retired, you’re withdrawing dollars from your portfolio. Retirees may have little flexbility when it comes to those withdrawals and need that portfolio to be resilient and long lasting.

The problem arises when you combine those withdrawals with a sequence of negative market returns in your first few years. In those scenarios, you chances of success are greatly lessened.

In the last post, I talked about the 4% rule and the risks that come with it and sequence risk is one of the big ones. In fact most of the failures that come with long term withdrawal periods come in times when sequence risk was most apparent and impacted people who retired right before a long market correction.

Example of Sequence Risk

Before we dive into that historical data, let’s visualize sequence of returns risk with a simple math exercise.

Imagine two investors who both have $1,000,000 and plan to withdraw 4% each year adjusted for inflation.

They start their retirement and one investor sees really terrible returns in the first three years while the other sees a great market in that same period. The returns flip in the latter years leading to average returns that are equal for both investors across a 10 year period. Those differences in returns in the first three years may not seem like much but they are hugely impactful to the overall return of the portfolio when combined with withdrawals.

In fact, with the below example, it’s pretty clear that the ending numbers are far from the same. This is what sequence risk is all about and why failures can often arise when retirement happens at an inopportune time without any ability to adjust.

Sequence of Returns Risk

Let’s break down the above and see why it works out that way.

The first retiree in red sees a terrible market for the first three years. Combine that with withdrawals and their portfolio is down quite a bit after the first three years dropping below $200,000. While the market recovers substantially after that and has very positive returns in most years, because that new starting point is so much lower due to market pressure and withdrawals, the recovery isn’t big enough to guarantee the success of this portfolio past year 10. That retiree is left with $124,000 which really isn’t enough to support a $48,000+ withdrawal going forward and is at significant risk of a full drawdown(portfolio going to $0).

On the other end, the second retiree in green sees a fantastic market in the first couple of years which more than covers their expenses and leaves them with a big nest egg by the time the huge market drop occurs. Despite the big recession in years 8-10, they are still left with a number that’s bigger than they started with.

Overall, the average returns in this ten year period are the same but it’s clear that when combined with withdrawals, the sequence in which the returns happen are important when it comes to end results. Thus, sequence of returns risk is the impact to your portfolio due to the order in which your returns happen. In simple terms, if those returns are very negative early in the lifecycle, it’s a bad thing and if they are positive early on, it’s a good thing.

The impact of the negative and positive returns does matter. For example, if the first few years of your portfolio are hit with a -3% market, the impact won’t be as great as if they are hit with a -30% market.

Now obviously this is a very skewed example that doesn’t seem like it could happen in real life but it does do a good job of illustrating just how important the time you retire is when it comes to the success of your retirement.

Real Examples of Sequence of Returns Risk

While an example like that may be good in illustrating the point, it’s also important to view this from a historical perspective because that’s where failures in any withdrawal timeline are most apparent. The numbers above may seem farcical but they’re not to far away from some of the rougher historical returns in the market.

Let’s take a look at the end of the roaring 20s and a guy named Mr. Unlucky who retired at the start of 1929 with their first withdrawal coming January 1st of that year right before the stock market crash that October. Mr. Unlucky wasn’t too open to changing his strategy and couldn’t go back to work due to the depression and had withdrawals right through the following years in the Great Depression. The market crash was swift and severe and lasted quite a few years but the recovery in the market did start to happen only a few years later in 1933. However, by that point, combined with the withdrawals(adjusted for negative inflation at the time), the portfolio was heavily punished.

For our second retiree, Ms. Lucky unknowingly retired right before the recovery started. How lucky!

Both of these retirees needed their funds for at least 30 years. For simplicity, let’s assume both were fully invested in the S&P 500 and both withdrawals were adjusted for inflation in the years they were retired(which fluctuated from -10% to 14% within their 30 year retirement period). The negative inflation actually helped Mr. Unlucky’s portfolio last longer as withdrawals were well below the starting point for a good portion of his life.

Let’s take a look at the results.

Sequence of Returns Risk

It looks like Mr. Unlucky really picked a bad time to retire as his funds lost nearly 80% of their value after withdrawals by 1932 and while 1933 was a banner year with a 53.9% return, the dollar totals he had by that time meant much smaller dollar returns which kept his portfolio low and kept Mr. Unlucky in a permanent state of dread.

In fact, the portfolio ran out of money by 1953, a few years before the 30 year time frame and poor Mr. Unlucky was out of luck.

Now, let’s look at Ms. Lucky who retired in 1933. Probably not a big difference right, how big a deal could a few years make?

Well, since Ms. Lucky skipped that entire massacre that so severely impacted the first portfolio, she fully benefited from that 53.9% in her first year and then was able to weather any down years easily as her nest egg kept on growing due to the positive returns in her early years. In fact, by the time she was nearing the end, she had built up quite a portfolio that could support a rather lavish lifestyle if she wanted to reset at the 4% rule again.

Isn’t it crazy how big a difference you see in the two portfolios despite how close they were to each other in time? It’s quite amazing that one portfolio grew to nearly $30M while the other ran out of money before 30 years. The visualization below is even more striking and tells the story fully.

Sequence of Returns Risk

So what caused such a stark difference? It was the sequence of returns that happened in the two portfolios. The 1929 retiree had a very awful sequence of returns that sent his portfolio in a downward spiral from which he could never recover while the 1933 portfolio started with a few years of very positive returns and could weather the storms that came after.

One thing to note is that while they both started with one million dollars, they did not have the same amount of money in reality. After all, starting with $1M after a major depression means you had to have a lot more in 1929 to get there but it’s still a very interesting example to picture and illustrates the point well.

It’s really impressive how just a few years can make all the difference.

And it’s not just the great depression where such large gaps exist. Let’s take a look at someone who retired right at the end of 1999 before the dot-com bubble when compared to someone who retired right at the end of 2002 when that bubble had pretty much finished bursting. I won’t show all the numbers like above but just the graph to illustrate the same point.

As above, both started with $1M dollars and withdrew 4% adjusted for inflation at the time. Does this look similar?

Sequence of Returns Risk

Yes, the initial example might have been a bit extreme but it’s starting to look a bit less so when you look at it through the lens of historical market returns.

Here, we have two people who retired a few years apart with the same amount and just two decades later are 10x apart in terms of what they have left over. The first portfolio, A, struggled with the highly negative returns in the first three years of retirement combined with withdrawals and never really recovered. On the other hand, the second portfolio, B, retired into a bull market and was able to weather the 2008 crash and keep climbing in the bull market that followed.

What was the difference? Again, it was their sequence of returns, one crappy and one great. Just as with the above example, it was really the first few years that mattered and either helped build a cushion to weather future storms in the case of a good sequence or buried you with negative returns combined with withdrawals making it hard to recover.

Now, the person with Portfolio A only has $329,077 left after 21 years and a bunch of stress to deal with then it comes to their expenses while person B is sitting pretty and can probably afford to spend a lot more without worrying too much about a future recession.

It’s an interesting conundrum and really shows that what matters most with your retirement is not the how much or the withdrawal but the when. A lot of the lucky retirees could have gone well above the 4% rule and still done well due to lucky timing on their part.

It’s the WHEN that really matters and that’s an interesting concept to understand. When testing the 4% rule as we saw in the last example, the failures are often caused by bad sequence of returns and the unlucky bunch that retire at the wrong time right before a major market crash.

It’s not just poor returns that can impact failures but also times other factors that go into it like inflation which had a huge impact on the 70s where your withdrawals had to suddenly soar to account for rising costs and market returns may fail to keep up.

So how can one choose the right when? Well, it’s not quite possible to do because predicting future market performance isn’t easy. On top of that, it’s the length that the market underperforms that matters. The above examples are problematic because the bear markets last for years and that hasn’t been the case recently.

The 2008 market crash only really had negative returns for one year although those negative returns were quite large. The pandemic crash barely lasted a few months before we were flying to heights not seen before. Those scenarios are far less impactful than a multi year bear cycle.

So the simple answer is, just avoid a multi year bear cycle early on in your retirement and you’ll probably be fine. EASY.

What’s interesting and quite obvious now that you think about it is that one is far better off retiring AFTER a market crash assuming your portfolio after said crash can still support your withdrawal rate. That’s because growth is sure to follow a crash and your portfolio already supports a safe withdrawal rate and should grow in the future leading to a much higher chance of success.

The risk actually is higher when retiring during a prolonged bull market. That’s what 1929 and 1999 were and those who retired during that period suffered as the market reverted back to the mean.

In essence, retiring today is probably more risky than retiring a few years and definitely more risky than retiring right after 2008 assuming same portfolio size which may seem counterintuitive but it’s quite true. That’s simply because the markets are so extended and there’s a variety of issues like the pandemic, inflation and supply chain concerns that might impact future returns.

At the end of the day, it’s the future returns that matter along with the sequence of those returns. It’s often the times where the market is most optimistic where the real risk lies and the opposite applies too, the opportunity is born when the market is most pessimistic. That not only applies to future market returns but also success rates of retirement strategies.

That doesn’t mean one shouldn’t retire today. After all, there are plenty of things to be optimistic about and market returns could continue to be great for years and years ahead.

However, it does mean that one should have some strategies in place to mitigate sequence of returns risk in case that doesn’t turn out to be the case.

Protecting Against Sequence of Returns Risk

What strategies would those be?

One is to simply build a bigger cache of savings and aim for a lower withdrawal rate. A 3.5% withdrawal rate leaves Mr. Unlucky above with $844,000 after 30 years instead of the failure with a 4% withdrawal rate. Saving a bit extra can have a major impact on success rates.

Another is to consider dynamic withdrawals which can really impact portfolio success rates during good times and bad.

Remember that the 4% rule tested in various studies is static and one can always withdraw more and stash it in cash for a future year during a bull market and then withdraw less during a bear market.

It’s also smart to have some safer investments to draw off in your early years if the stock market starts showing weakness. Keeping a year or two in expenses in cash isn’t technically the most efficient way to go about it since you miss out on stock market returns if they’re positive but that can help mitigate sequence risk if the reverse happens. The closer you get to retirement, the more you should consider the downside that can come with investing instead of focusing entirely on the upside as you should during your growth phase.

The same can be said for bonds which are much maligned now due to their low yields but they still serve a function as a place to draw funds from in case of sequence risk.

In fact, a diversified portfolio is an important aspect of success rates. Dividends and bond income can help weather the storm and prevent you from selling anything if they cover at least your basics costs during a downturn.

That’s one of the reasons we started contributing to IBonds in recent months which are now yielding a decent amount due to inflation. Building a bond ladder we can draw from in the event of a market crash will certainly make me feel better about retiring early since we won’t be forced to sell stocks at an inopportune time.

It’s also one of the reasons I keep 7.5% of my allocation in bonds in general as the asset can provide a safe haven when the market crashes.

It’s aggressive to be 92.5% in stocks. Many strategies as you get older call for bonds to increase as you get older and mirror your age minus ten which would mean I should be closer to 30% at my age. I prefer a more aggressive approach and am comfortable with that risk at my current age but will likely increase my bond allocation the closer I get to retirement. Bonds allocations have lost their luster with how amazing market returns have been in the last decade+ but it may serve us well when the reverse eventually happens.

It’s very easy to forget about a prolonged market downturn when we’ve lived in a fairy tale land of massive returns and quick recoveries but that might not last forever and it’s important to be ready for when that happens.

In summary, one of the biggest risk to any withdrawal strategies is sequence of returns risk and knowing about it and being ready for it is an important tool in any retiree’s arsenal.  While average returns are important, the order in which those returns happen combined with withdrawals can have a huge impact on the overall rate of return and health of a retiree’s portfolio. An adverse series of returns can have a very negative impact on said portfolio and increase the chances for a full drawdown before death. It’s important to take into account that possibility and take precautions in case that happens to help manage your portfolio better and prevent that from happening.


  • steveark

    Great plain language explanation of one of retirees’ biggest risks. We addressed this by being less aggressive in our asset allocation in retirement, having a bond and cash bucket, and by dropping from nearly all stocks to only 55% stocks in our portfolio. Plus I worked longer than I needed to because I was still having fun so our withdrawal rate is very low.

  • JC

    The sequence of returns are definitely a big concern. Hoping whenever we get to that point of making that decision that we are in a spot where 4% withdrawal covers everything and that’s just after a big market downturn. Not that it would change the outcome but it was something I was thinking about as I read it. In order for Ms Lucky to still be at $1M by 1933 she would have had to have roughly $5M invested already at the time that Mr Unlucky retired in 1929 assuming the Ms Lucky received the same market returns over the period between each retirement. It doesn’t change the illustration you’re making about sequence of returns risk, but for some reason that just popped into my mind as I was reading about them.

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