Risk Management

Sequence of Returns Risk: Protecting Your Retirement from Early Losses

The Hidden Danger to Early Retirement

Learn how sequence of returns risk can devastate early retirement and strategies to protect your portfolio including cash buffers, dynamic withdrawals, and bond tent approaches.

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5-10 Years

Highest Sequence Risk Period

2-3 Years

Recommended Cash Buffer

30%+

Loss Requiring Recovery Plan

3-3.5%

Conservative Initial Withdrawal

Quick Answer

Sequence risk is highest in the first 5-10 years of retirement - protect this period with lower equity exposure or cash buffers
A 30% loss in year 1 is far more damaging than the same loss in year 20 due to withdrawal amplification
Cash buffer strategy: Hold 2-3 years expenses to avoid selling equities during downturns
Dynamic withdrawals that decrease during bear markets provide automatic sequence risk protection
Bond tent strategy: Higher bonds at retirement, gradually increasing equities as sequence risk diminishes

Understanding

Why Sequence Risk Matters

Why Order Matters: The Math of Sequence Risk

Two portfolios with identical average returns can have vastly different outcomes based on when losses occur. A 30% loss in year 1 of retirement while withdrawing 4% devastates the portfolio. The same 30% loss in year 20 has minimal impact. The first 5-10 years of retirement are the danger zone.

The Retirement Red Zone: 5 Years Before and After

The period from 5 years before retirement through 10 years after is your highest sequence risk exposure. You have the largest portfolio, limited time to recover, and are beginning withdrawals. Risk reduction in this window is critical - this is not the time for aggressive growth strategies.

Withdrawal Amplification Effect

Sequence risk is amplified by withdrawals. Each dollar withdrawn during a downturn is a dollar that cannot recover. A 4% withdrawal from a portfolio down 30% requires selling 5.7% of original shares. This permanent loss compounds over decades - you cannot sell shares and have them recover.

Inflation Compounds the Problem

Rising expenses during market downturns force larger withdrawals at worst times. If you need $50,000 and inflation increases it to $55,000 while your portfolio is down 20%, you are withdrawing nearly 7% of current value instead of 4%. Inflation-adjusted withdrawal needs make sequence risk worse.

Implementation

Proven Strategies

Cash Buffer / Bucket Strategy

Maintain 2-3 years of expenses in cash or short-term bonds. During market downturns, spend from cash bucket instead of selling equities at depressed prices. Refill cash bucket during market recoveries. This provides time for equities to recover without forced selling.

Best for: Retirees seeking simple, systematic sequence risk protection with clear rules.

Example:

Retiree needs $80,000/year, has $2M portfolio. Strategy: Bucket 1 (cash) $160,000 (2 years), Bucket 2 (bonds) $400,000 (5 years), Bucket 3 (equities) $1,440,000. Market drops 40%: Bucket 3 falls to $864,000. Spend from Bucket 1 for 2 years while market recovers. No forced equity sales.

Dynamic Withdrawal Strategy

Adjust withdrawal rate based on portfolio performance. Common approach: Guardrails method - increase withdrawals when portfolio grows significantly, reduce when it declines. Flexibility in spending provides automatic sequence risk protection without large cash holdings.

Best for: Retirees with flexible spending and ability to reduce expenses during downturns.

Example:

Start with 4% initial withdrawal ($80,000 from $2M). Guardrails: If portfolio grows to $2.5M, increase withdrawal to 4.5% ($112,500). If portfolio falls to $1.6M, reduce to 3.5% ($56,000). Flexibility of $24,000/year provides protection without holding 2 years cash.

Bond Tent / Rising Equity Glidepath

Increase bond allocation in the years approaching and immediately following retirement (the "tent"), then gradually increase equity allocation as retirement progresses. Rationale: Highest sequence risk is early retirement; lower risk later when portfolio and remaining lifespan are both smaller.

Best for: Those comfortable with gradual allocation changes who want systematic sequence risk management.

Example:

At retirement: 40% equities, 60% bonds (conservative). Over 15 years, gradually shift to 60% equities, 40% bonds. Early years protected during peak sequence risk. Later years have more growth potential when sequence risk diminishes. Backtesting shows improved outcomes vs static allocation.

Avoid These Pitfalls

Common Mistakes

Retiring Into a Bear Market Without a Plan

Starting retirement during a 30%+ market decline with no sequence risk protection can permanently impair your portfolio. If you must retire during a downturn, have sufficient cash reserves (2-3 years) or dramatically reduce initial withdrawals until recovery. Flexibility is critical.

Maintaining Aggressive Allocation at Retirement

The allocation that built your wealth is not the allocation to protect it. Staying 90% equities at retirement maximizes sequence risk exposure. The retirement red zone calls for reduced equity exposure - you can increase it again 10-15 years into retirement when sequence risk diminishes.

Ignoring Sequence Risk Because "Markets Always Recover"

Markets do recover eventually, but your portfolio may not if you are withdrawing throughout the decline. A 50% loss requires 100% gain just to break even - without any withdrawals. With 4% annual withdrawals during a 3-year bear market, you need even larger gains. Time is not always on your side.

Questions

Common Questions

Here are the most common questions we receive about this topic.

Ask Your Question

Sequence risk is the danger that poor investment returns early in retirement permanently impair your portfolio because you are withdrawing funds that cannot recover. The order of returns matters as much as average returns when you are taking distributions.

Common recommendations range from 1-3 years of expenses in cash or short-term instruments. More conservative: 2-3 years. Less conservative: 1 year plus flexible spending ability. The key is having enough to avoid forced equity sales during typical bear market duration (1-3 years).

Sequence risk diminishes over time. The first 10 years of retirement have highest sequence risk because your portfolio is largest and you have longest withdrawal period ahead. After 15-20 years of successful retirement, remaining portfolio and lifespan are smaller, reducing impact of any single downturn.

The "4% rule" was designed for 30-year retirement with 50/50 allocation. Lower withdrawal rates (3-3.5%) provide more sequence risk protection. Flexible withdrawal strategies that reduce spending during downturns allow for higher initial rates. Your safe rate depends on allocation, flexibility, and retirement length.

Possibly. Working 1-2 additional years during a downturn means: continued contributions, not selling at lows, shorter retirement period to fund, and starting retirement at potentially recovered prices. If you have flexibility, delaying can significantly reduce sequence risk. But life circumstances may not permit waiting.

Ready to Protect Against Sequence Risk?

Sequence of returns risk is the hidden danger to early retirement. Let us help you create a strategy to protect your portfolio during the critical first years.

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