Retirees spend decades saving diligently and watching their balances grow, confident they’ve prepared well for retirement. Yet one often-overlooked factor can disrupt even the strongest plan: sequence-of-returns risk.
Unlike market averages or account balances, sequence-of-returns risk isn’t something you’ll see listed on a statement. But the timing of market gains and losses, especially in the early years of retirement, can have a major impact on how long your portfolio lasts. Understanding this risk can help you make more informed decisions and create a strategy designed for greater long-term stability and sustainable income.
What Is Sequence-of-Returns Risk?
When you’re working or actively contributing to your retirement fund, market fluctuations may not have a long-term effect on your finances as long as the average return is solid and your portfolio grows in value. In fact, market fluctuations actually help you while you are in your accumulation phase. Your invested dollar buys more shares when the market is down than it does when the market is up. This is the benefit of dollar-cost-averaging.
In retirement, however, that dynamic reverses itself. After you retire and start making withdrawals from your portfolio, sequence-of-returns risk can become an issue. It’s all about the order of your investment gains and losses after you retire. If the market faces a downturn in the initial months of your retirement, you might experience drastic losses that could drop your balance quickly.
An Example of Sequence-of-Returns Risk
To illustrate how the sequence of returns can affect your investments, let’s look at a hypothetical retiree. They have $500,000 in their retirement fund and withdraw $25,000 every year in retirement.
Now, consider the following two scenarios, each spanning 10 years:
- Scenario 1: The market enjoys positive gains in the early years of retirement but generates losses in later years.
- Scenario 2: The market starts out with steep losses and suboptimal returns but rebounds in later years.
In both scenarios, the average return over 10 years is the same: 3%.
| Scenario 1 | ||||
| Year | Account Balance | Return | Distribution | Final Balance in Account |
| 1 | 500,000 | 10% | 25,000 | $ 525,000.00 |
| 2 | $ 525,000.00 | 15% | 25,000 | $ 578,750.00 |
| 3 | $ 578,750.00 | 5% | 25,000 | $ 582,687.50 |
| 4 | $ 582,687.50 | 10% | 25,000 | $ 615,956.25 |
| 5 | $ 615,956.25 | 10% | 25,000 | $ 652,551.88 |
| 6 | $ 652,551.88 | 15% | 25,000 | $ 725,434.66 |
| 7 | $ 725,434.66 | -5% | 25,000 | $ 664,162.92 |
| 8 | $ 664,162.92 | -15% | 25,000 | $ 539,538.48 |
| 9 | $ 539,538.48 | -5% | 25,000 | $ 487,561.56 |
| 10 | $ 487,561.56 | -10% | 25,000 | $ 413,805.40 |
| Avg Return | 3% | |||
| Scenario 2 | ||||
| Year | Account Balance | Return | Distribution | Final Balance in Account |
| 1 | 500,000 | -10% | 25,000 | $ 425,000.00 |
| 2 | $ 425,000.00 | -5% | 25,000 | $ 378,750.00 |
| 3 | $ 378,750.00 | -15% | 25,000 | $ 296,937.50 |
| 4 | $ 296,937.50 | -5% | 25,000 | $ 257,090.63 |
| 5 | $ 257,090.63 | 15% | 25,000 | $ 270,654.22 |
| 6 | $ 270,654.22 | 10% | 25,000 | $ 272,719.64 |
| 7 | $ 272,719.64 | 10% | 25,000 | $ 274,991.60 |
| 8 | $ 274,991.60 | 5% | 25,000 | $ 263,741.18 |
| 9 | $ 263,741.18 | 15% | 25,000 | $ 278,302.36 |
| 10 | $ 278,302.36 | 10% | 25,000 | $ 281,132.60 |
| Avg Return | 3% | |||
Although they have the same average return over the course of a decade, the ending balance at year 10 in Scenario 1 is $413,805.40. Even with the gradual improvement in returns, the account balance after 10 years in Scenario 2 is $281,132.60—a stunning $132,672.80 less than Scenario 1.
The Role of Reverse Compounding
This significant gap between the two outcomes is due to a concept called reverse compounding. In a typical growing account, compounding allows investment earnings to generate their own earnings over time. Taking regular distributions during a market downturn causes the opposite effect.
When reviewing the hypothetical examples above, both scenarios feature a 15% market return at different points. In the first hypothetical scenario, the 15% gain occurs in year two, when the account balance is $525,000.00. That single year adds $78,750.00 in investment growth to the portfolio.
In the second hypothetical scenario, the 15% gain does not occur until year five, after the portfolio has already absorbed consecutive losses and ongoing distributions. By that time, the starting balance for the year has dropped to $257,090.63. Growing a smaller amount of money yields far fewer total dollars, even with an identical percentage return. Withdrawing money from a declining fund shrinks the core investment pool, leaving fewer dollars at work to benefit when the market eventually recovers.
Steps to Lessen the Impact of Sequence-of-Returns Risk
The most sensible way to reduce the impact of sequence-of-returns risk is to start taking withdrawals on your retirement when the market is going up. However, if you’ve already experienced a market loss due to sequence-of-returns risk, there are options for mitigating long-term risk.
Reserve Cash for Emergencies
Keep one or two years’ worth of living expenses in your cash reserves, separate from your retirement fund, to avoid selling securities for cash withdrawals during a market downturn. Stash your emergency fund in a cash or low-volatility brokerage account.
Have Some Flexibility With Withdrawals
Scale back on your withdrawals and spending when the market is down. You can also pause inflation adjustments if needed.
Coordinate Social Security Timing
Delaying Social Security benefits can serve as an effective buffer against early market volatility. By waiting to collect benefits, the monthly payout increases, creating a higher baseline of guaranteed income later in retirement. This larger income stream permanently reduces the amount of money you need to withdraw from your investment portfolio each year, minimizing the pressure on your assets during a market downturn.
Establish a Tiered Portfolio Structure
Organizing investments based on when you will need the money can protect your short-term spending. In this setup, you allocate funds into different categories based on time horizons. Short-term needs over the next few years are held in stable vehicles like money markets or short-term bonds. This structure gives your growth-oriented investments, such as equities, the time they need to recover from a market drop, since you are not forced to liquidate them to cover daily expenses.
Consider an Annuity
An annuity is a steady income source that can safeguard you from the effects of market losses. It can also keep you from outliving your savings.
Reducing Sequence-of-Returns Risk for Long-Term Stability
At Tapparo Capital Management, we look beyond short-term performance to help clients build lasting financial wealth. By thoughtfully balancing goals, resources, and risk, you can create strategies designed for sustainable growth and a strong sequence of returns over time.
About Andy
Andrew Tapparo is a fee-only financial advisor at Tapparo Capital Management, a financial planning firm in Topsfield, MA. As a Retirement Income Certified Professional (RICP®), he designs retirement strategies along with sound money management to help clients retire with confidence.
