Sequence of returns risk is a critical yet often overlooked factor in retirement planning. It refers to the risk that the order in which investment returns occur—especially during the early years of retirement—can significantly impact the longevity of your savings.
Even if the average return over time remains the same, withdrawing money during market downturns can deplete a retirement portfolio faster than expected. Understanding this risk is essential for those pursuing financial independence and aiming for a secure retirement.
Why Sequence of Returns Risk Matters
Many investors assume that as long as they earn an average return of 7-10% annually from an S&P 500 index fund, their portfolio will grow predictably over time. However, this assumption overlooks the impact of timing.
A retiree who starts withdrawing funds during a stock market downturn may find their portfolio shrinking at a much faster rate than someone who begins withdrawing during a bull market.
For example, imagine two retirees with identical portfolios who experience the same average returns over 30 years but in different sequences. The retiree who faces negative returns early in retirement may exhaust their savings decades earlier than the one who experiences market gains first.
How Sequence of Returns Risk Affects Retirees
This risk primarily impacts individuals who are actively withdrawing from their retirement accounts, such as those relying on a 401(k), IRA, or taxable investment accounts. Here’s why:
- Early Withdrawals from a Declining Portfolio: If you withdraw money while your investments are down, you lock in losses. This reduces the overall balance, making it harder for your portfolio to recover when the market rebounds.
- Compounding in Reverse: Just as compounding growth benefits investors who let their money sit, withdrawing during market downturns has the opposite effect. A depleted portfolio has less capital to grow when the market recovers.
- Long-Term Sustainability Issues: Retirees who experience poor returns early in retirement may need to reduce their withdrawal rate or risk running out of money sooner than planned.
A Worked Example: Two Retirees, Same Average Return
Averages hide the damage, so here is the damage in dollars. Two retirees each start with $1,000,000 and withdraw $40,000 at the start of every year. Both earn the same returns over six years, 20 percent three times and negative 20 percent three times, for an average return of zero percent either way. The only difference is the order.
Retiree A gets the good years first. Her $1 million grows to about $1,553,000 after three good years of withdrawals, then the three bad years pull her back to roughly $717,000.
Retiree B gets the bad years first. After three down years of withdrawals, she is down to about $434,000. The good years recover her to roughly $575,000, but the hole was too deep.
Same portfolio, same average return, same $240,000 withdrawn over six years. Retiree A ends with $717,000. Retiree B ends with $575,000. The $142,000 gap is sequence of returns risk, measured in dollars. This is why the first five to ten years of retirement matter more than any other stretch of an investor’s life, and why a cash buffer is not conservative. It is insurance against the one risk no average can capture.
Strategies to Mitigate Sequence of Returns Risk
While sequence of returns risk can’t be eliminated, it can be managed with smart financial planning. Here are some key strategies to protect your retirement savings:
Maintain a Cash Buffer
One of the best ways to protect against sequence of returns risk is to keep a portion of your retirement savings in cash or a high-yield savings account to cover 1-3 years of expenses. This buffer allows retirees to avoid selling stocks during market downturns.
Use the Bucket Strategy
The bucket strategy involves dividing your retirement savings into different “buckets” based on when you’ll need the money:
- Short-term (1-3 years): Cash, high-yield savings, short-term treasury bills
- Medium-term (3-10 years): Bonds, dividend stocks
- Long-term (10+ years): S&P 500 index funds and other growth investments
This approach ensures that you’re not forced to sell stocks at a loss during market downturns.
Adjust Your Withdrawal Rate
Many financial advisors recommend the 4% rule, which suggests withdrawing 4% of your portfolio in the first year of retirement and adjusting for inflation each year. However, flexibility is key. If the market is down, reducing withdrawals temporarily can help preserve long-term financial stability.
Consider a Bond Ladder or Treasury Bills
Investing in short-term treasury bills or a bond ladder provides predictable income and reduces reliance on stock market returns. This can be particularly helpful in the early years of retirement.
Delay Social Security
Delaying Social Security benefits until age 70 can provide higher guaranteed income, reducing the need to withdraw from investments during downturns.
Diversify Your Portfolio
While the S&P 500 has historically provided strong returns, diversification is still important. A well-balanced portfolio with a mix of stocks, bonds, and alternative assets can reduce the impact of market volatility.
The Bond Tent: Spend Down Conservatively, Then Get Aggressive
The counterintuitive fix for sequence risk comes from research by Michael Kitces and Wade Pfau. Their finding surprised even them: in retirement, a rising equity glidepath, starting conservative and getting more aggressive over time, reduced both the probability and the magnitude of portfolio failure.
The logic is the mirror image of the worked example above. The scenarios that kill a retirement are the bad early years. A rising glidepath keeps you less exposed to stocks when you are most vulnerable, then lets equity exposure climb back up once the danger zone has passed and the good returns have room to work. Kitces calls the shape a bond tent: build an extra reserve of bonds in the years before and just after retirement, then spend that reserve down over the first decade.
This runs against the folk wisdom that you should get more conservative as you age. That advice fits the accumulation years. In the withdrawal years, the evidence points the other way: protect the early years aggressively, then let the portfolio breathe. A cash buffer handles the first one to three years. The bond tent handles the decade.
Final Thoughts
Sequence of returns risk is a crucial consideration for anyone planning for retirement or financial independence. Even with a strong portfolio, poor market timing can derail a well-thought-out retirement plan. By maintaining a cash buffer, using a bucket strategy, adjusting withdrawals, and diversifying investments, retirees can safeguard their financial future and ensure their savings last.
Smart planning today can help you weather market downturns and enjoy a secure, comfortable retirement.
Winchell House 
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