The risk no one warns about

Sequence of Returns Risk

The order in which investment returns arrive makes no difference to a portfolio that is left alone. Once withdrawals begin, it makes a considerable difference, and a sound portfolio offers no protection against it. The effect is known as sequence of returns risk. It is greatest in the years just before and just after retirement.

Walter’s story

Everything done right, at the wrong time

In 2008, Walter Higgins retired at sixty-six after a career with the postal service. He had saved steadily, and he claimed Social Security on schedule. That year the S&P 500 lost 37 percent, its worst calendar year since the Great Depression. Walter’s portfolio fell at the moment he needed to begin drawing on it.

Walter went back to work, and his Social Security benefit was suspended. Withdrawals from a portfolio that had just fallen that far would have required selling shares at low prices, and those shares would not have been present for the recovery. A paycheck removed the need to touch the portfolio, so it was left alone to recover.

Walter’s finances recovered. Other plans did not. The trips to visit his daughter’s three children were postponed for several years, and by the time his finances were steady, the grandchildren were teenagers. The cause was not how the market performed. It was when.

Two retirees, the same fifteen returns

Only the order changes

The illustration below compares two retirees. Each begins with $2,000,000, each withdraws $200,000 at the start of every year for fifteen years, and each earns the same fifteen annual returns, which average 11.3 percent. The only difference is the order in which the returns arrive.

Scenario AStrong years first
YearStart of yearReturnWithdrawal
1$2,000,0005.78%$200,000
2$1,904,04018.59%$200,000
3$2,020,82131.16%$200,000
4$2,388,1896.08%$200,000
5$2,321,23127.04%$200,000
6$2,694,90215.55%$200,000
7$2,882,983(4.64%)$200,000
8$2,558,49231.65%$200,000
9$3,104,95518.53%$200,000
10$3,443,2436.59%$200,000
11$3,456,973(7.03%)$200,000
12$3,028,00823.72%$200,000
13$3,498,81136.90%$200,000
14$4,516,072(25.95%)$200,000
15$3,196,051(14.42%)$200,000
Left after 15 years$2,564,02111.3% avg$3,000,000
Scenario BWeak years first: the same returns, reversed
YearStart of yearReturnWithdrawal
1$2,000,000(14.42%)$200,000
2$1,540,483(25.95%)$200,000
3$992,68636.90%$200,000
4$1,085,20223.72%$200,000
5$1,095,142(7.03%)$200,000
6$832,2516.59%$200,000
7$673,93518.53%$200,000
8$561,76031.65%$200,000
9$476,246(4.64%)$200,000
10$263,42715.55%$200,000
11$73,29027.04%$73,290
12$06.08%$0
13$031.16%$0
14$018.59%$0
15$05.78%$0
Left after 15 years$011.3% avg$2,073,290

The first retiree withdraws $3,000,000 over fifteen years and finishes with $2,564,021. The second runs short in year eleven, when only $73,290 remains to be withdrawn, and has nothing left for the last four years. The starting balance, the withdrawals, the returns, and the average were the same in both cases.

Scenario A: strong years firstScenario B: weak years first
Two retirees, the same fifteen returnsStrong years first ends with $2,564,021. Weak years first runs out of money in year 11.$0$1M$2M$3M$4M123456789101112131415EndYear of retirement (balance at the start of each year)Strong years first, year 1: $2,000,000Strong years first, year 2: $1,904,040Strong years first, year 3: $2,020,821Strong years first, year 4: $2,388,189Strong years first, year 5: $2,321,231Strong years first, year 6: $2,694,902Strong years first, year 7: $2,882,983Strong years first, year 8: $2,558,492Strong years first, year 9: $3,104,955Strong years first, year 10: $3,443,243Strong years first, year 11: $3,456,973Strong years first, year 12: $3,028,008Strong years first, year 13: $3,498,811Strong years first, year 14: $4,516,072Strong years first, year 15: $3,196,051Strong years first, year end: $2,564,021Weak years first, year 1: $2,000,000Weak years first, year 2: $1,540,483Weak years first, year 3: $992,686Weak years first, year 4: $1,085,202Weak years first, year 5: $1,095,142Weak years first, year 6: $832,251Weak years first, year 7: $673,935Weak years first, year 8: $561,760Weak years first, year 9: $476,246Weak years first, year 10: $263,427Weak years first, year 11: $73,290Weak years first, year 12: $0Weak years first, year 13: $0Weak years first, year 14: $0Weak years first, year 15: $0Weak years first, year end: $0$2,564,021 leftOut of money in year 11
The two scenarios above, drawn from the same numbers. Hypothetical illustration.

Both retirees could say truthfully that they averaged 11.3 percent a year for fifteen years. The average describes how a portfolio grows when it is left alone. It does not describe whether a portfolio can support withdrawals.

The arithmetic of losses

Why the order matters more than the average

A loss and a gain of the same percentage do not cancel. A loss of 20 percent requires a gain of 25 percent to return to the starting point, and a loss of 50 percent requires a gain of 100 percent.

LossGain needed to recover
10%11.1%
20%25.0%
30%42.9%
50%100.0%

While contributions are still being made, this arithmetic is manageable. Once withdrawals have begun, it behaves differently. Every dollar taken from a portfolio that has just fallen is raised by selling more shares at a lower price, and those shares are not present when the recovery arrives. For that reason a loss in the first year of retirement does far more damage than the same loss in the fifteenth year, when fewer withdrawals remain to be taken from the smaller balance.

Not only 2008

The danger is the timing, not the crisis

In 2022, the S&P 500 fell about 18 percent, its worst calendar year since 2008. A retiree who began withdrawals early in 2022 took that loss in the first year of retirement, which is the year in which a loss does the most damage. No crisis is required. A decline that arrives early is enough.

Managing the risk

A buffer first, and three measures beside it

The most direct answer is a volatility buffer: an account that is not exposed to market losses and can be reached in the year it is needed. In a down year, income is drawn from the buffer, so nothing has to be sold at a loss. How a buffer is built and sized is explained on its own page, The Volatility Buffer.

Three other measures work alongside it:

  1. Flexible withdrawals. A smaller withdrawal in a down year, even a modest reduction, takes pressure off the portfolio when it is most exposed.
  2. A floor of dependable income. Social Security, a pension, or annuity income covers expenses without the sale of any investment. Each dollar provided by that floor is a dollar the portfolio does not have to provide in a down year.
  3. A sustainable withdrawal rate. The smaller the share of the portfolio withdrawn each year, the less damage any sequence of returns can do.

The short version

  • The average return describes how a portfolio grows. The order of returns determines whether it survives withdrawals.
  • Order makes no difference while money is being saved, and a large difference once it is being spent.
  • The years just before and just after retirement carry the most weight.
  • A volatility buffer, flexible withdrawals, a floor of dependable income, and a sustainable withdrawal rate are the means of planning around it.

A review of your own figures

A Retirement Analysis shows how a 2008 or a 2022 in the first year of retirement would affect your income plan, and how a volatility buffer would change the result. It takes about twenty minutes on a screen share, and there is no cost.

Request a Retirement Analysis

Chapter 2 of Don’t Run Out sets out both scenarios in full. About the book

Hypothetical illustration, constructed to isolate one variable, which is the order in which returns arrive. It is not a projection, a guarantee, or a recommendation, and it reflects no specific product or account. Returns are shown rounded to two decimal places. A withdrawal of $200,000 from a balance of $2,000,000 is an annual rate of 10 percent, used to make the effect clearly visible and higher than any rate ordinarily considered sustainable. S&P 500 figures for 2008 and 2022 are calendar-year total returns. General education only. Not investment, tax, or legal advice. Goat Planning · Jeff Batson, RFC® · VA Life & Health License #1236200 · NPN #19629974 · Licensed in 20 states.