Sequence-of-returns risk explained

Sequence-of-returns risk is the risk that a portfolio's bad years come at the wrong time. For someone who is taking regular withdrawals, a market decline early in retirement can do more lasting harm than the same decline many years later. The term sounds technical, but the idea rests on simple arithmetic.

Why order matters only when money is moving

If nothing is added to or taken from an account, the order of its yearly results does not affect where it ends up. A loss of 20% followed by a gain of 20% leaves the same balance as a gain of 20% followed by a loss of 20%, because multiplication gives the same answer in either order.

That changes once withdrawals begin. Money taken out after a decline is money that is no longer invested when prices recover. Each withdrawal during a downturn uses up a larger share of what remains.

A hypothetical illustration

The figures below are invented to show the mechanics. They use round, deliberately simple returns and do not represent any actual market period, any expected result or any particular investment.

Two retirees each start with $500,000 and withdraw $25,000 at the beginning of each year. Over three years they experience the same three yearly results, in opposite order.

Both withdrew $75,000 in total. Both had the same three results. Retiree A, whose loss came first, finishes with $20,000 less.

Without any withdrawals, both accounts would have ended at exactly $480,000. The entire difference comes from the timing of the loss relative to the withdrawals. Over a retirement lasting decades, with larger swings, the gap can become much wider.

When the risk is highest

The exposure is greatest in the years shortly before and shortly after retirement. This is when the balance is typically at its largest, so a given percentage decline removes the most dollars, and when the longest stretch of withdrawals still lies ahead.

A decline late in retirement matters less for the opposite reasons. Fewer years of withdrawals remain to be funded.

The mirror image for savers

The same arithmetic works in reverse for someone still contributing. A worker who is adding money every month buys more shares when prices are low. For a young saver with a small balance and decades of contributions ahead, weak markets early on affect a relatively small amount of money.

This is one reason the same market decline can mean very different things to a 30-year-old and a 64-year-old who hold identical investments.

Common ways people respond

No approach removes the risk, and none can be shown in advance to produce a better result than another. Each of the following trades one concern for a different one.

Holding a reserve of cash or short-term holdings. Some retirees keep a year or more of planned withdrawals outside of stocks, so that spending during a downturn does not require selling at low prices. The tradeoff is that money held in reserve may not keep pace with rising prices. Investor.gov describes inflation risk as the principal concern for people investing in cash equivalents.

Adjusting the investment mix near retirement. Some investors gradually hold less in stocks as retirement approaches. Investor.gov notes that people with a shorter time horizon may prefer less volatile investments. The tradeoff may be less potential for growth over a retirement that may last decades. Target-date funds are built around this kind of shift.

Flexible spending. Reducing withdrawals after a decline, or skipping an inflation increase, leaves more invested. This works only to the extent that part of the budget is truly optional. The post on the 4% rule and its limits describes several flexible withdrawal methods.

Income that does not depend on markets. Social Security, a pension or a fixed income annuity generally pays an amount that does not move with the market. The more of a household's essential costs these cover, the less it has to withdraw in a bad year. Annuities carry their own costs and limits, which the SEC describes on its annuities page.

Flexibility about timing. Working somewhat longer, or earning part-time income in the first years of retirement, shortens the period of withdrawals and may reduce early withdrawals. This is not available to everyone, since health and the job market do not always cooperate.

Common misunderstandings

"It is the same as market risk." Market risk is the chance that investments lose value. Sequence risk is about when the loss happens in relation to withdrawals. Two people can face the same market and have very different outcomes.

"Average returns tell the story." In the example above, both retirees had identical average results. Averages hide the order, and for someone taking withdrawals the order matters.

"It can be predicted." Nobody knows whether the first years of a given retirement will be strong or weak. The risk is managed by preparing for either outcome, not by forecasting.

Questions worth asking

• If the portfolio fell sharply in the first few years of retirement, where would spending money come from?
• How much of the planned budget could be reduced for a year or two?
• What share of essential expenses is covered by income that does not vary with the market?
• Is the current investment mix one that could be held through a decline without selling at a low point?

Thinking through these questions ahead of time is the practical use of the concept. It is one of the moving parts covered in turning savings into retirement income.