Sequence of Returns Risk: Don’t Risk Your Retirement

Sequence of returns risk is a concept that often goes unnoticed during the retirement planning phase, yet it has a significant impact on financial security in retirement. This risk becomes particularly important when retirees begin drawing down from their savings. The sequence in which market returns occur can make or break a retirement income strategy, especially during volatile market periods.

This article provides an introduction to sequence of returns risk, exploring its impact, mitigation strategies, and solutions for retirees.

What is Sequence of Returns Risk?

Sequence of returns risk refers to the danger that the order and timing of market returns can have on a retirement portfolio. Unlike those in the accumulation phase, retirees rely on withdrawals from their savings. When retirees experience negative market returns early in retirement, it can lead to “portfolio depletion,” which is when a portfolio cannot sustain the retiree’s needs over time.

Karsten Jeske, also known as Big ERN, highlights this in his Forget About Money podcast appearance: “If you start withdrawals at the peak and the market falls, even a high average return over 30 years may not save you. It’s the sequence—good years followed by bad—that matters most.”

Example: The Timing of Returns

Imagine two retirees, each with identical portfolios averaging a 5% annual return over 30 years. The difference? One faces negative returns in the first decade, while the other experiences strong positive returns early on. The retiree facing negative returns at the outset may see their portfolio deplete much faster, despite both portfolios averaging the same return. This sequence risk is a critical factor in retirement planning, as it illustrates that the timing of returns is often more impactful than the average return itself.

Why Does Sequence of Returns Risk Matter in Retirement?

Market volatility is inevitable, and for retirees, it can have significant consequences. When withdrawals coincide with down markets, each withdrawal further reduces the portfolio’s ability to recover, especially if there is no other income stream. As Jeske explains, “The first 5-10 years of retirement matter most. If there’s a recession during that time, the ability to maintain your lifestyle and income over the long term is at risk.”

How to Mitigate Sequence of Returns Risk

Fortunately, there are strategies that can help minimize the impact of sequence of returns risk on retirement planning. From adjusting asset allocation to adopting flexible withdrawal strategies, these approaches provide a foundation for more resilient retirement income strategies.

1. Create a Diversified Portfolio with a Balanced Asset Allocation

Diversifying across asset classes, including stocks, bonds, and cash equivalents, helps spread the risk. Jeske emphasizes the importance of a diversified portfolio, suggesting that retirees allocate around 60-80% in stocks with the remaining 20-40% in bonds or other safe assets. “If you are in retirement and using your portfolio for income, avoid being 100% in stocks. A diversified portfolio that includes bonds provides a cushion against volatility,” says Jeske​.

The key is to balance growth with stability, using bonds and other fixed-income assets to mitigate the impact of negative market returns on the overall portfolio.

Reverse Glide Path Strategy

A reverse glide path strategy involves starting with a more conservative allocation at retirement (e.g., 60% stocks, 40% bonds) and gradually increasing equity exposure over time. This approach can help protect the portfolio during the critical early years of retirement, while later reintroducing growth potential.

“Starting with more bonds and slowly transitioning back into equities can shield a portfolio against the worst effects of sequence risk,” Jeske explains. He underscores the effectiveness of this strategy for retirees because it offers early protection while capturing growth in later years​.

2. Use a Flexible Withdrawal Strategy

Flexible withdrawal strategies allow retirees to adjust their spending based on market performance. Jeske advocates for this approach: “If the market is down, consider withdrawing a little less. Flexibility can be an effective guard against depleting your portfolio too quickly.”

Reducing Withdrawals During Market Downturns

One simple method is to temporarily reduce withdrawals when the market is in a downturn, only increasing withdrawals when the market recovers. This flexibility helps conserve assets and prevent further losses in a bear market.

Spending Guardrails

Some retirees establish spending “guardrails,” setting an upper and lower limit for withdrawals based on portfolio performance. If the portfolio declines below a certain threshold, withdrawals are reduced, while a portfolio exceeding a high threshold may allow for increased spending. This strategy ensures that spending remains sustainable while allowing retirees to enjoy their savings in good years.

3. Avoid the Bucketing Strategy Trap

Although popular, the bucketing strategy—where retirees separate funds into different “buckets” for short-term, medium-term, and long-term spending—may not always provide the anticipated security. Jeske warns against over-relying on this method: “The bucket strategy may appear secure on paper, but it does not inherently protect against sequence risk. You’re still drawing from the same portfolio over time.”

While it’s not a harmful approach, Jeske emphasizes that retirees should be cautious and understand that this method does not eliminate sequence of returns risk.

Common Questions About Sequence of Returns Risk

What Spending Strategy Eliminates Sequence of Returns Risk?

No single strategy can eliminate sequence of returns risk entirely, but adopting a flexible spending strategy provides a robust response. Retirees who are willing to adjust their spending in response to market conditions can better weather market downturns and protect their assets.

How Can Retirees Avoid Sequence of Returns Risk?

Retirees can reduce the risk by maintaining a diversified portfolio, adjusting their withdrawal rates based on market performance, and incorporating bonds or other low-risk assets to balance market exposure. Additionally, using strategies like the reverse glide path or a flexible spending approach can offer substantial protection.

Can Sequence of Returns Risk Be Eliminated?

While it’s impossible to completely eliminate sequence of returns risk, retirees can mitigate its impact through careful planning and flexible retirement strategies. Jeske advises caution, especially for those “retiring at a market peak,” underscoring the importance of timing, asset allocation, and withdrawal flexibility​.

Conclusion: Achieving Financial Security in Retirement

Sequence of returns risk is a crucial factor in any retirement income strategy. For retirees, the key to managing this risk lies in staying flexible, maintaining a balanced asset allocation, and being prepared for market volatility. By adopting strategies like diversified portfolios, reverse glide path adjustments, and adaptable withdrawal rates, retirees can improve their chances of financial security and manage the unique challenges that sequence risk presents.

As Jeske highlights, understanding and preparing for sequence of returns risk is an essential part of retirement planning. Through proactive planning, retirees can navigate the timing of market returns and secure a stable financial future.

Guidance for the Savers:

• Don’t sweat sequence risk (too much): If you are just starting your path to save for retirement or even if you’re three to five years away from retirement the prospect of a bear market around the corner is a lot less concerning. If the drop in the stock market is followed by a swift recovery as has been common historically, you can even greatly benefit from that scenario through dollar cost averaging!

Guidance for the current and soon-to-be-retired:

• Thinking about retiring as soon as you hit your FI number, i.e., 25x expenses? Don’t be too impatient about retiring. You might set yourself up for failure because you are more likely to retire at the market peak right before Sequence Risk strikes again. It might be best to target a higher savings target (i.e., a lower safe withdrawal rate) just to be sure.
• Retirees might consider a bond glidepath: Pick a higher bond share early on to hedge against bad equity returns during the first few years of retirement. But shift back into equities again because we need equities with their much higher expected return to sustain a retirement over the decades.
• Another way to mitigate Sequence Risk would be to tie the withdrawal rates to financial fundamentals, especially stock valuations like the Shiller CAPE Ratio. Withdraw a lower percentage from the portfolio when equities are expensive and a drawdown is more likely, but then also increase the withdrawal percentage after stocks drop and valuations become more attractive again.

Additional Resources:

• How Much Money Do I Need to Be Financially Independent?  at fiology.com
• Understanding Sequence Of Returns Risk – Safe Withdrawal Rates, Bear Market Crashes, And Bad Decades  by Michael Kitses of kitces.com
• The Ultimate Guide to Safe Withdrawal Rates – Part 14: Sequence of Return Risk  by Karsten “Big Ern” Jeske of earlyretirementnow.com
• The Ultimate Guide to Safe Withdrawal Rates – Part 15: More Thoughts on Sequence of Returns Risk  by Karsten “Big Ern” Jeske of earlyretirementnow.com
• 035 | Sequence Of Return Risk | Early Retirement Now  by Brad Barrett and Jonathan Mendonsa of choosefi.com

Take Action:

1. Sequence of Returns Risk impacts savers and retirees differently, thus, there are also different recommendations:

Quote:

“Any goal worth achieving involves an element of risk.” – Dean Karnazes