Retirement provides an opportunity to pursue personal interests and cherish time with family, but it also comes with unique challenges—especially when it comes to managing your investments.
For a comprehensive approach to ensure your peace of mind, consider exploring our Retirement Planning strategies.
One of the most significant risks retirees face is sequence of return risk, which can derail even the best-laid retirement plans. If you’re unfamiliar with this term, don’t worry—you’re not alone. Most pre-retirees aren’t aware of it until they start living off their portfolio.
Sequence of return risk refers to the timing of investment returns and how it impacts your ability to sustain withdrawals during retirement. Even if two retirees have identical portfolios and withdrawal rates, their outcomes can differ dramatically based on whether they retire into a bull or bear market. In this article, we’ll break down what sequence of return risk is, why it matters, and—most importantly—how you can protect against it using three proven strategies.
Part 1: Understanding Sequence of Return Risk
What Is Sequence of Return Risk?
In simple terms, sequence of return risk is the danger that poor market performance early in retirement will deplete your portfolio faster than expected. Unlike during your working years, when you’re contributing to your portfolio, retirement means you’re withdrawing from it. If the market drops significantly while you’re selling assets to fund your lifestyle, those losses are permanent—you won’t have the opportunity to recover them as you would during your accumulation phase.
The Math Behind the Risk
Let’s use an example to illustrate this concept:
Imagine two retirees, John and Jane, both starting with $1 million portfolios. They plan to withdraw $50,000 annually (a 5% withdrawal rate) and expect their portfolios to grow at an average annual rate of 6%. Despite these similarities, their outcomes could be vastly different depending on the sequence of returns:
- John retires into a bull market: His portfolio grows steadily in the first few years, giving him a cushion to withstand future downturns. By the end of his retirement, he still has money left.
- Jane retires into a bear market: Her portfolio loses 20% in the first year. She still needs to withdraw $50,000, so she’s forced to sell more shares at lower prices. This compounds her losses, making it harder for her portfolio to recover—even if markets rebound later.
Despite averaging the same 6% return over 30 years, Jane runs out of money much sooner than John because of the bad timing of her withdrawals.
Real-World Example: The S&P 500 from 2000 to 2018
To drive this point home, consider someone who retired in January 2000 with $1 million invested entirely in the S&P 500 and planned to withdraw $50,000 annually (adjusted for inflation). Over the next 18 years, the S&P 500 averaged about 6.5% annually—a respectable return. However, due to the severe downturns in 2000-2002, 2008, and other market volatility, this retiree would have run out of money by 2018.
This example highlights why sequence of return risk is so critical: It’s not just about average returns—it’s about when those returns occur relative to your withdrawals.
Part 2: Common Misconceptions About Sequence Risk
Many people mistakenly believe that any market downturn during retirement automatically means they need to cut spending. While reducing expenses might sometimes be wise, it’s not always necessary—if you’ve planned properly.
Historical Context: William Bengen’s Research
The concept of sequence of return risk was first explored in depth by financial planner William Bengen in 1994. His groundbreaking research led to the creation of the 4% rule, which suggests that retirees can safely withdraw 4% of their initial portfolio value (adjusted for inflation) each year without running out of money over a 30-year retirement period.
Bengen tested his theory against some of the worst historical market conditions, including:
- The Little Dipper (1929-1931): The early Great Depression years saw the U.S. stock market lose 61% of its value, but deflation offset part of the damage.
- The Big Dipper (1937-1941): A prolonged downturn combined with rising inflation created a challenging environment for retirees.
- The Big Bang (1973-1974): A devastating combination of high inflation (22%) and steep market losses (-37%) resulted in a real return loss of nearly 60%.
Even in these extreme scenarios, Bengen found that a 4% withdrawal rate allowed portfolios to last at least 30 years—and often much longer.
Part 3: Contextualizing Today’s Market Conditions
It’s easy to panic when markets decline, especially if you’ve recently retired. However, putting current events into historical perspective can help alleviate some of that fear.
For instance, let’s compare the 2022 market downturn to the 1973-1974 recession:
- 2022: The S&P 500 dropped approximately 18%, and inflation rose by 8%, resulting in a real return loss of 26%.
- 1973-1974: Markets fell 37%, and inflation surged 22%, leading to a real return loss of nearly 60%.
While 2022 was certainly unpleasant, it pales in comparison to the severity of the 1970s. Historical data shows that retirees who stuck to sustainable withdrawal rates during tough times were able to weather the storm and maintain their financial security.
Part 4: Three Proven Protection Strategies
Now that we understand sequence of return risk, let’s discuss how to protect against it. Here are three key strategies:
Strategy #1: Sustainable Initial Withdrawal Rates
Starting with a withdrawal rate that accounts for potential market volatility is crucial. The 4% rule remains a solid guideline, but depending on your goals and timeline, you may want to adjust it:
- More Conservative Approach: If you’re retiring early or planning for a longer retirement, consider a 3-3.5% withdrawal rate.
- Balancing Safety and Lifestyle: Remember, being overly conservative can limit your enjoyment of retirement funds. Find a balance that works for you.
Strategy #2: Strategic Withdrawal Sequencing
Your withdrawal strategy is just as important as your withdrawal rate. Instead of blindly pulling money from all accounts equally, focus on:
- Selling Assets That Have Grown or Stayed Stable: Avoid liquidating underperforming assets during downturns. For example, if stocks are down but bonds are holding steady, prioritize withdrawals from the bond portion of your portfolio.
- Guardrails Approach: Use cash reserves or low-volatility assets to cover expenses during market declines, allowing your equities time to recover.
Strategy #3: Diversification with Purpose
Every asset in your portfolio should serve a specific purpose. A well-diversified portfolio includes:
- Cash Reserves: Maintain 1-3 years’ worth of living expenses in cash or short-term bonds to avoid selling depreciated assets during downturns.
- Growth-Oriented Investments: Stocks and other growth assets provide long-term appreciation but come with volatility.
- Stability-Oriented Investments: Bonds and dividend-paying stocks offer stability and income to cushion against market swings.
By diversifying intentionally, you insulate yourself from having to sell assets at inopportune times.
Part 5: Implementing These Strategies in Your Retirement Plan
To determine whether sequence risk poses a threat to your retirement, ask yourself (or your financial advisor):
- How sensitive is my plan to market downturns?
- Am I using tools like Monte Carlo analysis to stress-test my strategy?
- Do I have enough cash reserves to ride out a prolonged bear market?
Monte Carlo simulations, which model thousands of potential market scenarios, can help gauge your plan’s resilience. While no tool can predict the future, these analyses provide valuable insights into your plan’s strengths and weaknesses.
Conclusion
Sequence of return risk is a legitimate concern, but it’s manageable with proper planning. By adopting sustainable withdrawal rates, implementing strategic withdrawal sequencing, and building a diversified portfolio with clear objectives, you can protect your retirement savings from market volatility.
Remember, the psychological benefits of having a plan cannot be overstated. Knowing you’ve accounted for worst-case scenarios allows you to enjoy retirement with confidence, regardless of short-term market fluctuations.
Ready to evaluate your own retirement income strategy? Check out our FREE retirement blueprint course, including a guide to common retirement tax mistakes and tools to help you plan effectively.
