Sequence-of-Returns Risk: Why the Order of Market Returns Matters in Retirement
Two retirees can earn the same average return over thirty years and end up in completely different places. The difference is timing.
During the saving years, a market decline is an inconvenience: contributions keep flowing and the portfolio has time to recover. Once withdrawals begin, the arithmetic changes. Selling shares into a falling market to fund living expenses permanently removes those shares from the portfolio, and the recovery, when it comes, applies to a smaller base. This is sequence-of-returns risk, and it is one of the central problems of retirement planning.
The mechanism
Schwab's explanation of sequence risk uses a hypothetical comparison of two investors, each starting with $1 million and withdrawing $50,000 a year. One experiences a 15% decline in the first two years of retirement; the other experiences the same decline in years ten and eleven. With otherwise identical returns, the first investor's portfolio is depleted in roughly 18 years, while the second still holds close to $400,000 at that point. The average return was the same. The order was not.
Kitces.com makes the broader point that the sustainability of withdrawals is driven far more by the sequence of returns than by the long-term average. In its analysis of historical 30-year retirements, the same initial withdrawal rate that failed in the worst cases also produced, in other cases, ending balances several times the starting amount. Retirement outcomes are distributed widely, and the early years carry disproportionate weight.
Why it matters more for early retirees
Sequence risk grows with the length of the withdrawal period. A Silicon Valley professional who leaves full-time work at 50 after a liquidity event may be drawing on a portfolio for 40 years or more, often without Social Security or pension income for the first decade or longer. The 4% rule, which originated in William Bengen's 1994 work, was calibrated to a 30-year horizon and a specific historical record; researchers including William Sharpe have questioned whether a fixed real withdrawal from a volatile portfolio is an efficient way to fund stable spending at all. An earlier retirement with a longer horizon generally calls for a more conservative starting withdrawal rate, more flexibility, or both.
Bay Area costs sharpen the problem. A household with a large mortgage and property tax on a home assessed at recent values has less room to cut back when markets fall, and fixed spending is exactly what makes sequence risk dangerous.
Approaches that reduce exposure
None of these eliminates the risk, and each has a cost.
A cash and short-term bond reserve covering one to several years of spending, which Schwab describes as one year in cash and two to four years in high-quality short-term bonds, allows withdrawals to come from the reserve rather than from equities during a decline. The cost is lower expected growth on the reserve.
Flexible withdrawal rules that reduce spending after a bad year, or skip inflation adjustments, can extend portfolio life; Schwab's illustration shows a portfolio recovering from an early decline in about 11.5 years at a 2% withdrawal rate versus 28 years at 4%. The cost is a less predictable lifestyle.
A rising equity glide path, in which the stock allocation starts lower at retirement and increases over time, reduces exposure during the most vulnerable early years. The cost is giving up some growth if early returns are strong.
Delaying Social Security, which for those born in 1960 or later has a full retirement age of 67, increases guaranteed inflation-adjusted income later, reducing the portfolio's burden in the years when longevity risk peaks. The cost is drawing more from the portfolio in the interim.
Partial annuitization or a bond ladder that covers essential expenses for a defined period removes those expenses from market exposure at the cost of liquidity and, for annuities, fees and insurer credit risk.
Sequence risk works both ways
The same mechanism that hurts retirees who begin withdrawing into a decline helps those who retire into a strong market. Kitces.com notes that historically, retirees at a 4% withdrawal rate were about as likely to finish with several times their starting wealth as to finish below it. A plan that only guards against the downside may leave a retiree spending less than they could have; periodic reassessment allows spending to adjust in both directions.
Sequence risk cannot be predicted or timed, and any plan that depends on avoiding a downturn in the first years of retirement is fragile. This article is educational only and is not investment, tax, or legal advice; consider consulting a qualified professional about your own retirement plan.
Important Disclosures
Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.
