What is sequence of returns risk?
By Nicolas Straut
Key takeaways
- A retiree who started in 1966 with $1,000,000 in 60% stocks and 40% bonds, taking $40,000 a year raised for inflation, ran out of money in year 27, and the same 30 years of returns in reverse order left $1.6 million.1
- Sequence of returns risk comes from withdrawals: with no money taken out, any order of the same yearly returns ends at the same balance.
- The 4% rule was built around the worst US starting years, and you can test your own plan by moving the worst years to the start in the Tweed Monte Carlo Retirement Calculator.
In this article
Key takeaways
- A retiree who started in 1966 with $1,000,000 in 60% stocks and 40% bonds, taking $40,000 a year raised for inflation, ran out of money in year 27, and the same 30 years of returns in reverse order left $1.6 million.1
- Sequence of returns risk comes from withdrawals: with no money taken out, any order of the same yearly returns ends at the same balance.
- The 4% rule was built around the worst US starting years, and you can test your own plan by moving the worst years to the start in the Tweed Monte Carlo Retirement Calculator.
Sequence of returns risk is the risk that market losses early in retirement, when you're withdrawing money, leave you with less than the same losses later would. Two retirees with the same average return can end up far apart, and one can run out of money, only because their bad years came in a different order.
It matters most in the years just before and after you stop working. This guide explains why withdrawals cause it, shows it in real market history, and covers four ways retirees reduce it.
What is sequence of returns risk?
Sequence of returns risk is the effect the order of your yearly returns has on how long your savings last once you start withdrawing from them. Your average return over a retirement can be fine and your plan can still fail, if the losses come first.
It's a risk of timing, not of a bad investment. The same fund, held by two people who retire five years apart, can give them very different results.
How sequence of returns risk works
Sequence of returns risk works through withdrawals. Money you take out in a down year comes from selling shares at low prices, and those shares aren't there when prices recover.
Without withdrawals, order makes no difference. Growing 10% and then losing 20% leaves the same balance as losing 20% and then growing 10%: $100,000 × 1.10 × 0.80 = $100,000 × 0.80 × 1.10 = $88,000.
Now take out $10,000 at the start of each year. The two orders no longer match:
| Order | Year 1 | Year 2 |
|---|---|---|
| Gain first | ($100,000 − $10,000) × 1.10 = $99,000 | ($99,000 − $10,000) × 0.80 = $71,200 |
| Loss first | ($100,000 − $10,000) × 0.80 = $72,000 | ($72,000 − $10,000) × 1.10 = $68,200 |
The loss-first retiree sold shares after the fall and had fewer left for the rise. The $3,000 gap comes from the order alone.
When sequence of returns risk is highest
Sequence of returns risk is highest in the years just before and just after you retire, when your balance is at its largest and withdrawals are about to start or have just started. A loss late in your career hits the biggest balance you'll ever have, and you have few saving years left to rebuild it. Early in your career, a loss costs much less, because new contributions buy shares at lower prices.
Early retirees face this risk for longer, because their savings may need to last 40 years or more. The FIRE movement guide covers the other risks of retiring early, and how much you need to retire covers the target balance.
Sequence of returns risk example
This sequence of returns risk example takes the real yearly returns from 1966 to 1995 for a 60% stock, 40% bond mix and runs them in two orders, with the same $40,000 withdrawal at the start of every year, adjusted for inflation. Both retirees start with $1,000,000.
| After year | Historical order (1966 first) | Reversed order (1995 first) |
|---|---|---|
| 1 | $885,632 | $1,229,589 |
| 5 | $763,694 | $1,384,026 |
| 10 | $502,082 | $1,742,517 |
| 20 | $204,316 | $2,347,679 |
| 25 | $55,223 | $1,896,626 |
| 30 | Ran out in year 27 | $1,622,792 |
Tweed calculation. S&P 500 with dividends and 10-year Treasury bond returns from NYU Stern, adjusted by annual average CPI-U from the Minneapolis Fed, rebalanced yearly, in starting-year dollars. No taxes or fees.2
Over those 30 years, the average real return was 4.06% a year in either order. With no withdrawals, both orders end at $3,297,577. The only difference is when the bad years landed: the 1966 retiree met the inflation and bear markets of the late 1960s and 1970s first.
Sequence of returns risk vs market risk
Sequence of returns risk and market risk differ in three ways: what each one measures, when each one can hurt you, and what reduces each one.
| Sequence of returns risk | Market risk | |
|---|---|---|
| What it measures | The order of returns | The size of returns and losses |
| When it can hurt you | Only when money goes in or comes out, most of all in the years around retirement | Any time you hold investments |
| What reduces it | Flexible withdrawals, a cash reserve, and guaranteed income | Holding a mix of investments, and holding less in stocks |
A portfolio you never withdraw from carries market risk with no sequence risk. You can't have sequence risk without market risk, though, because the order only matters when returns go up and down.
How the 4% rule handles sequence of returns risk
The 4% rule handles sequence of returns risk by setting the first withdrawal at a level that survived the worst US starting years, not the average ones. William Bengen's 1994 study tested every starting year from 1926 and found that a 4% first-year withdrawal, raised for inflation, lasted at least 33 years in every case. That includes retirements that began just before the 1973 to 1974 decline, which he found the most damaging.3
The Trinity study's 30-year results point the same way. A 4% withdrawal raised for inflation lasted in 95% of periods with 50% stocks and 98% of periods with 75% stocks.4
The 4% rule guide covers the assumptions behind those numbers.
How to reduce sequence of returns risk
Four things reduce sequence of returns risk: a cash reserve, lower spending after bad years, guaranteed income, and a lower starting withdrawal rate. Each one has a cost.
Keep a cash reserve
A cash reserve of one to three years of spending lets you skip selling investments after a market fall. The cost is that cash earns less than stocks over time, so a large reserve lowers your long-run growth.
A bucket strategy is the same idea in three tiers: cash for the next few years, bonds after that, and stocks for the long run. A CD ladder is one way to hold the cash tier.
Spend less after a bad year
Spending less after a bad year means taking less from your portfolio when prices are low, which leaves more shares for the recovery. Bengen's own paper suggests that retirees hit by a bad stretch "reduce withdrawals slightly for a period of time." The cost is an income that moves with markets.
Add guaranteed income
Guaranteed income, such as Social Security or an income annuity, covers part of your spending whatever markets do, so your portfolio has to sell less in a down year. Delaying Social Security raises your monthly benefit. The cost is drawing more from savings in the years you wait. To see what an income annuity would pay, the Tweed annuity calculator shows the monthly payout a lump sum buys.
The Tweed Social Security Plan compares filing ages. The Tweed retirement withdrawal plan sets your filing ages together with which account to spend from while you wait. The guide to retirement withdrawal order explains how that choice changes your tax.
Start with a lower withdrawal rate
A lower starting withdrawal rate leaves more room for a bad start, because each year's withdrawal is a smaller share of your balance. Bengen found that 3% never ran out in under 50 years. The cost is that you'll spend less every year, including all the years markets do well.
To see what a bad start would do to your own plan, the Tweed Monte Carlo Retirement Calculator runs your balance and spending through 10,000 market paths. Its Bad years first switch moves each path's two worst years to the start, so you can compare the two success rates. To size the balance itself first, use the Tweed Retirement Calculator.
Frequently asked questions about sequence of returns risk
How long does sequence of returns risk last?
Sequence of returns risk lasts as long as you're withdrawing from your savings. Once your portfolio has grown well past what you need, or you have only a few years of spending left to cover, a bad year does less lasting damage, because each withdrawal is a smaller share of what's left.
Does sequence of returns risk affect bonds?
Sequence of returns risk affects bonds too, though bond losses are usually smaller than stock losses. In 2022, 10-year Treasury bonds lost 17.83% and the S&P 500 lost 18.04%, so a retiree selling either one to fund spending sold at low prices. Bonds and stocks have fallen in the same year before.
Does an annuity protect against sequence of returns risk?
An income annuity protects against sequence of returns risk for the part of your spending it covers, because its payments don't change with markets. The trade is that the money you buy it with is no longer yours to invest or leave to heirs. The Tweed Annuity Calculator shows what a premium buys.
Is sequence of returns risk worse when inflation is high?
Sequence of returns risk is worse when inflation is high, because withdrawals that rise with prices take a bigger bite just as real returns fall. Consumer prices rose about 11% in 1974, the same year the S&P 500 lost 25.90%. A retiree that year had to sell more shares, at lower prices, to buy the same things.
Is sequence risk the same as sequence of returns risk?
Sequence risk is the same as sequence of returns risk: both names describe how the order of returns changes the outcome once you're withdrawing. Some planners call it sequence of withdrawals risk, because returns are outside your control and the withdrawals are what turn an early loss into a lasting one.
Sources
- https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
- https://www.minneapolisfed.org/about-us/monetary-policy/inflation-calculator/consumer-price-index-1913-
- https://www.financialplanningassociation.org/sites/default/files/2021-04/MAR04%20Determining%20Withdrawal%20Rates%20Using%20Historical%20Data.pdf
- https://www.aaii.com/journal/article/retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable
Tweed provides educational estimates, not financial advice. Confirm your specific situation with a qualified financial professional.
Personal finance writer, former Forbes contributor and This Week in Fintech writer. He isn't a financial advisor or a CPA.
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