Sequence of returns risk: why the order of returns matters in retirement

While you are saving, a market fall can even be helpful, because your regular contributions buy more shares at lower prices. Once you start withdrawing, the same fall is more damaging. This is sequence of returns risk: the danger that poor returns arrive early in retirement. Two people can earn the same average return and finish very differently. Understanding why helps you plan to avoid being caught out.

What it means

The risk is not just about how much a portfolio returns on average. It is about the order in which the returns arrive. When you are withdrawing money, early losses are especially costly because you are selling investments at low prices to fund spending, so there is less left to benefit when markets recover.

A numerical illustration

Imagine two retirees, each starting with 1,000,000 and withdrawing 40,000 at the start of each year. Over three years they experience the same three annual returns of -20%, +10% and +20%, but in a different order.

Retiree A gets the bad year first (-20%, +10%, +20%).

• Year 1: withdraw 40,000, leaving 960,000. After -20%, the portfolio is 768,000.
• Year 2: withdraw 40,000, leaving 728,000. After +10%, it is 800,800.
• Year 3: withdraw 40,000, leaving 760,800. After +20%, it is 912,960.

Retiree B gets the bad year last (+20%, +10%, -20%).

• Year 1: withdraw 40,000, leaving 960,000. After +20%, it is 1,152,000.
• Year 2: withdraw 40,000, leaving 1,112,000. After +10%, it is 1,223,200.
• Year 3: withdraw 40,000, leaving 1,183,200. After -20%, it is 946,560.

Both experienced identical returns, and both withdrew the same amounts, yet B finishes about 33,600 ahead after only three years. In later years the gap tends to widen, because the smaller portfolio has less capital to grow. If nobody was withdrawing, the order would not matter at all, since multiplying the same returns gives the same result in any order.

Why it matters more for early retirees

A longer retirement has more years in which a poor start can compound. People retiring in their 40s or 50s also have more years of withdrawals ahead of them, and less time to rely on future earnings if things go wrong. Sequence risk is therefore a particularly important issue for the FIRE community.

Ways to reduce the risk

You cannot predict the order of returns, but you can design a plan that does not depend on a lucky start.

• Hold a cash or short-term reserve. Keeping one to two years of spending in cash or short-term bonds means you do not need to sell shares during a downturn. You can refill the reserve when markets recover.
• Be flexible with spending. Trimming withdrawals after a weak year, even by a modest percentage, can substantially improve the odds that the money lasts. Planning which expenses are discretionary helps.
• Diversify. A mix of shares, bonds and other assets can reduce the size of the falls. The right mix depends on your tolerance for risk and your time horizon.
• Consider a glide path. Some retirees hold less in shares around the start of retirement, then gradually increase the share as the first, riskiest years pass. This approach is debated, so look at the evidence and your own situation.
• Use other income early on. Part-time work or other income in the first years reduces how much you withdraw when markets may be weak.
• Choose a lower starting withdrawal rate if you want more margin, particularly for a long retirement.
• Delay big optional purchases until markets have recovered, where you can.

What to do if a downturn strikes early

If markets fall sharply soon after you retire, avoid panic selling. Review your plan, draw from your cash reserve if you have one, reduce discretionary spending for a while, and consider whether any other income is possible. Small adjustments made early are far more effective than large ones made late.

Common mistakes

• Looking only at average returns.
• Holding everything in shares with no reserve at the start of retirement.
• Refusing to cut spending in a bad year.
• Retiring on a plan with no margin for error.
• Selling investments in a panic after a fall.

A short checklist

• I understand that the order of returns matters once I withdraw.
• I have a reserve covering one to two years of spending.
• I know which expenses I could reduce in a poor year.
• My portfolio is diversified in line with my risk tolerance.
• I will review the plan each year.

Sequence risk cannot be removed, but it can be managed. A cushion, some flexibility and a diversified portfolio make a plan far more resilient.