Sequence-of-Returns Risk: The Retirement Threat Nobody Talks About Until Year Three

Most people spend the decade before retirement thinking about getting to the number. Save enough. Build the portfolio. Hit the target.

The question that gets far less attention is what happens in the first few years after you stop working. That period is when sequence-of-returns risk is most dangerous, and most retirees do not hear about it until they have already experienced it.

What is sequence-of-returns risk in retirement?

If you are still working and contributing to a portfolio, a down market year is not inherently dangerous. You buy more at lower prices. The loss is on paper. Time is on your side.

When you retire and begin withdrawing from the portfolio, the dynamic flips. A down market year means you are selling shares at lower prices to fund your living expenses. Those shares are gone. When the market recovers, they do not come back. Your remaining portfolio participates in the recovery, but from a smaller base.

That is the core of sequence risk. The order in which returns arrive matters, not just the average. Two portfolios that produce the same 30-year average return can have dramatically different outcomes if one experiences its losses early and the other experiences them late.

Why does a bad market in early retirement hurt more than a bad market later?

The math is most damaging early because the portfolio is at its largest. A 20% decline in year one of retirement hits a larger dollar amount than a 20% decline in year twenty, when withdrawals have already reduced the portfolio. And in year one, you are selling shares into the decline to fund expenses.

Here is a simplified illustration. A retiree with a $1.5 million portfolio withdrawing $60,000 per year experiences a 25% decline in year one. The portfolio drops to $1.125 million before the withdrawal, then to $1.065 million after. If the market does not recover for two or three years and withdrawals continue, the portfolio can drop to a level from which recovery is unlikely to be sufficient to sustain the original withdrawal rate for a 30-year retirement.

Now run the same scenario in reverse. The strong returns come first, the portfolio grows to $1.8 million or $2 million before the bad years hit, and the withdrawal is a smaller percentage of a larger base. The outcome is significantly different, even if the 30-year average return is identical.

How much can poor sequence hurt my retirement income?

The honest answer is: more than most people expect, and the range of outcomes is wide. Retirement research has consistently shown that the first 10 years of returns have an outsized influence on whether a retirement portfolio survives a 30-year retirement at a given withdrawal rate.

The 4% rule, which suggests withdrawing 4% of your initial portfolio per year, adjusted for inflation, has historically shown a high success rate over 30-year periods. But that success rate assumes average market behavior over the period. Retirements that began in 1966 or 2000, both periods of poor early-retirement returns, were significantly more challenged than retirements that began in 1982 or 2010.

A Colorado retiree who retired in early 2022 and began taking withdrawals faced a difficult first year, with significant equity and bond market declines. The question for those retirees is whether the plan was built to absorb that kind of opening sequence. For many, it was. For some, it is worth a closer look.

What strategies help protect against sequence-of-returns risk?

Several approaches exist, and most well-constructed retirement income plans incorporate more than one.

Variable withdrawal rates. Rather than taking a fixed dollar amount regardless of market conditions, adjusting your withdrawal up or down based on portfolio performance provides a buffer. A year where the portfolio declines significantly, you pull back on discretionary spending. This is psychologically difficult but mechanically effective.

Dynamic spending rules. Guardrail strategies define a percentage of the portfolio as the withdrawal rate and allow withdrawals to float within a band. If the portfolio declines past a threshold, spending drops. If it grows past another threshold, spending can increase. Vanguard and other researchers have published evidence supporting this approach.

Asset allocation management. Holding more in fixed income or cash in early retirement can reduce the magnitude of early drawdowns. The trade-off is lower long-term expected returns. The right balance depends on the specific plan.

The bucket strategy and cash buffer. Maintaining one to two years of expenses in cash, outside the investment portfolio, means you do not have to sell equity during a down market to fund living expenses. You draw from cash while the portfolio recovers.

How does a cash bucket or bond ladder reduce sequence risk?

A cash buffer or bond ladder creates a bridge between the portfolio and the income need. The idea is simple: if you have two years of expenses in a money market or short-term bond account, a one-year bear market does not force you to sell equity. You draw from the buffer while the portfolio recovers.

A bond ladder extends this further. Purchasing individual bonds that mature in year one, year two, year three, and so on may create a more predictable income stream for a defined period. The equity portion of the portfolio can recover without being tapped.

The limitation: cash and short-term bonds drag on long-term performance. A retiree who holds three years of expenses in cash through a 15-year equity bull market gave up meaningful growth. The strategy protects against the bad scenario at the cost of some upside in the good one.

Should I delay retirement if markets are down?

Not necessarily, but the decision is worth thinking through more carefully than most people do. If your retirement date is flexible by one to two years, retiring into a portfolio that has already recovered from a significant decline is materially different from retiring at the peak.

The other variable is the income bridge. Social Security claiming strategy, pension timing, and part-time income in early retirement all affect how much the portfolio needs to produce in the first few years. The less the portfolio needs to be tapped in years one through three, the lower the sequence risk exposure.

If you are within five years of retirement and your plan has not specifically addressed sequence risk, that is a conversation worth having now, not after the first significant drawdown.

Looking back at your own investment experience, how did you handle the down years, and does your retirement plan reflect what you actually did versus what the model assumed?

These are general planning concepts and not a recommendation for your specific retirement income strategy. Sequence risk and withdrawal rate decisions depend on individual circumstances including portfolio size, income sources, time horizon, and risk tolerance. If you would like to review your retirement income plan with sequence risk specifically in mind, schedule a complimentary call. Link to Calendar

Disclosure: This article is for informational and educational purposes only and does not constitute investment advice specific to your situation. Investing involves risk including possible loss of principal. Withdrawal strategies and retirement income projections are illustrations only and do not guarantee specific outcomes. Mountain Legacy Family Wealth Partners does not guarantee any investment results. Consult your financial advisor before making changes to your retirement withdrawal strategy.

Disclaimer: The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without IFP's express prior written consent. Neither IFP Advisors LLC, IFP Securities LLC, dba Independent Financial Partners (IFP), nor their affiliates offer tax or legal advice. Any potential tax advantages or benefits will depend on your circumstances. Consult your tax professional and/or legal expert about your individual tax situation and visit IRS.gov to learn more.