Sequence of Return Risk in Retirement Explained

Financially reviewed by Patrick Flood, CFA.

Sequence of return risk may very well ruin your financial retirement plans, and all from sheer bad luck. Here we’ll look at the nature and implications of sequence of return risk in retirement, and some proposed solutions to at least mitigate its potential negative impact.

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What Is Sequence of Return Risk?

Sequence of return refers to the variability of year-to-year market returns. The “risk” thereof specifically refers to how the timing of withdrawals during retirement can negatively impact the value and viability of the portfolio going forward. 

At retirement, you are likely no longer making contributions and are instead withdrawing money each year. Since these withdrawals don’t get replenished by new contributions, the sequence of your returns matters. Withdrawals hurt the future portfolio value more in bear markets and less during bull markets, as you are withdrawing proportionally more during the former and proportionally less during the latter. The combination of withdrawing and poor portfolio performance may deplete it so much that you later exhaust the retirement savings that are left.

Markets are largely unpredictable. The expected average annualized return of your investment portfolio is not going to happen every single year. The long-term averaging out or “self correcting” of the stock market doesn’t help over a short period like 5 to 10 years, during which sequence of return risk may ruin the rest of your retirement. In short, if you get a “bad sequence” of returns at the beginning of your retirement, you may run out of money later, and your planned safe withdrawal rate is no longer safe.

Since all crystal balls are cloudy, the type of sequence you get is unfortunately simply a matter of luck. Maybe the best examples of getting the bad luck of a “bad sequence” would be someone entering retirement in 2000 at the height of the Dotcom Bubble or in 2008 at the start of the Global Financial Crisis.

The famous “4% rule” as a safe withdrawal rate estimate for retirement planning was born of this sequence risk.

The Potential Upside of Sequence Risk

It’s not all bad news, though. On the flip side, starting retirement with a “good sequence” of returns means you’ll have more money – in fact, much more – than you expected later in retirement, allowing you to sail along unscathed and worry-free and providing the ability to spend more.

Interestingly, the potential impact is asymmetrical and favors the upside. That is, due to the power of compounding during bull markets, the magnitude of potential benefit from starting with a “good sequence” outweighs the magnitude of the potential detriment of starting with a “bad sequence.” In short, a good sequence provides more “good” than a bad sequence provides “bad.”

Michael Kitces, famous financial advisor and retirement researcher, notes how the extremely wide possibility of outcomes from different sequences dictates that investors still withdraw conservatively and smartly “just in case,” even though there exists the potential for massive upside. He explains:

…on average a 4% initial withdrawal rate results in the retiree finishing with nearly triple the original principal, on top of sustaining an initial withdrawal rate of 4% adjusted annually for inflation! In fact, in only 10% of the scenarios does the retiree even finish with less than 100% of their starting principal (and in only one of those scenarios does the final value run all the way down to having nothing at the end, which of course is what defines the 4% initial withdrawal as “safe” in the first place).

As usual, hope for the best but plan for the worst.

Sequence of Return Risk Charts

The graph below illustrates the above points – that even with the same average annual return, the investor entering retirement in a bull market is far better off later than the investor who enters retirement during a bear market – for a hypothetical scenario:

Here’s a chart for the same data:

The graph below illustrates how the two sides of the luck coin have played out historically using the empirical data:

Kitces illustrates the dangerous implications of what’s shown above – that even bumping up to just a 5% withdrawal rate (from 4%) fails 25% of the time in historical scenarios with a 60/40 portfolio:

Kitces also illustrates the wide variability of possible outcomes and potential upside of sequence risk:

Sequence of Return Risk and Asset Types

Naturally, assets like treasury bonds – especially those of shorter durations – have comparatively less sequence of return risk than things like stocks, gold, and real estate. That is, the year-to-year returns of bonds are more predictable and less volatile than the latter assets. On the extremes, the risk-free asset (1-month T Bills) has zero sequence risk and leveraged equities have the most sequence risk.

Bonds are typically increasingly added as time passes for precisely that reason, to decrease the portfolio’s overall volatility and risk. This is why diversification becomes even more important near retirement in favor of capital preservation over massive gains. A young investor with a 30-year time horizon can afford to be – and arguably should be – invested in 100% stocks precisely because they don’t need to worry about sequence risk early in the accumulation phase, during which they’re also likely not making any withdrawals.

That is, young investors can afford to have bad years – and even strings of consecutively bad years – from which their portfolio can later recover. A retiree doesn’t have that luxury; for them, consistency of returns is as important as – and arguably more important than – the size of those returns.

Mitigating Sequence of Return Risk – Possible Solutions

A seemingly obvious answer to reduce sequence risk is to try to change the portfolio in anticipation of market behavior, known colloquially as market timing. Unfortunately, the evidence tells us this doesn’t really work, and market timing is actually usually more harmful than helpful.

Another obvious solution is to simply work a few more a years to increase the starting value of the portfolio entering retirement, but that doesn’t sound fun.

So what about tackling spending and how that affects withdrawals?

The first idea is to simply cut expenses during bad market years to save money so that you can live normally when the market recovers. 

A more involved, likely more optimal approach is to use specific decision criteria like Jonathan Guyton’s “guardrails” to indicate when to pull back on withdrawals and spending. If your withdrawal percentage is creeping up naturally, i.e. your portfolio’s value is decreasing to where your necessary withdrawal amount to cover expenses is increasing as a percentage of portfolio value, then cut expenses. 

For example, with a portfolio value of $1,000,000 and annual living expenses of $40,000, you have a 4% withdrawal rate, said to be a pretty safe estimator for retirement planning. If your portfolio value dips to $900,000, your $40,000 in expenses now comprise 4.4% of the portfolio’s value. The retiree may decide to cut expenses if their withdrawal rate reaches 5%, for example, and give themselves a raise if their withdrawal rate reaches 3%. This is likely a more sensible approach than simply letting market performance per se dictate spending.

Kitces maintains that what’s objectively even better than that is to make small, permanent cuts to expenses where you can. This invariably decreases the withdrawal percentage and permanently improves the portfolio value through compounding in future years when you still don’t have that particular expense. Due to the power of compounding, he suggests that these small cuts in expenses are ironically more impactful over the rest of the retirement horizon than the aforementioned larger but temporary cuts.

Recent research from Michael Kitces and Wade Pfau suggests that a tactical asset allocation strategy layered on top of this variable spending criteria idea can further mitigate sequence risk by doing the precise opposite of the traditional wisdom – getting more aggressive by allocating more to stocks as your retirement progresses. 

Sounds crazy, right? The traditional wisdom that seems perfectly intuitive is a declining equity glidepath, which says to decrease risk by allocating more to bonds as time goes on. The idea to do the opposite is not as farfetched as it may seem at first glance. Given the “bad” scenario of a market downturn at the beginning of one’s retirement that recovers later, the research from Kitces suggests that on average, it is better to be more in stocks later to ride that recovery back up, rather than crashing with mostly stocks (which will hurt worse) and recovering with mostly bonds (which will recover less of the portfolio’s value). 

This is perhaps a difficult concept to accept and put into practice, but Kitces suggests you can easily do this by simply being more conservative than you already would be when going into retirement, and then titrate up in equities to be slightly less conservative as time goes on. He’s not at all advocating that retirees should be shifting to 100% equities. 

A realistic example would be going into retirement with something ultra-conservative like 30/70 stocks/bonds and then gradually moving to 50/50 or whatever your “normal” risk tolerance would allow. As he puts it, “shelter in the bond tent” for the first 10 years, spend it down, and then “get back to normal” with the portfolio you would have had in the first place as you emerge.

Using a Withdrawal Policy Statement

The aforementioned criteria and tactics could be put into a Withdrawal Policy Statement (WPS) that establishes strict parameters for how portfolio withdrawals will be handled, similar to how an Investment Policy Statement (IPS) establishes guidelines for how the portfolio’s investments will be handled on an ongoing basis. 

These Statements help eliminate any emotional, knee-jerk reactions to market fluctuations that will likely be more harmful than helpful. They also eliminate needless stress over uncontrollable, unpredictable market volatility, as well as the subsequent worry about whether or not you’re doing the right thing with the portfolio based on that volatility. Without adherence to these parameters and clear thresholds, you are likely to make more short-term adjustments to the portfolio and may miss the forest for the trees. Setting parameters means market fluctuations are only actionable if they exceed the bounds you’ve set for the portfolio’s value, withdrawal percentage, etc. Simply having the plan makes it easier to follow the plan.

Conclusion

Sequence of return risk is often overlooked and can potentially be massively detrimental to your financial retirement plans. Understand the risks of a “bad sequence” when entering retirement and establish a strategy to mitigate it, all while hoping for some good luck and a “good” sequence.

Do you employ tactics to reduce sequence risk? Let me know in the comments.

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Disclaimer:  While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.