5.1.4 Sequence of Returns Risk (Deeper)

Revisiting why this risk concentrates early in retirement

A retiree withdrawing a fixed amount each year from a portfolio that also happens to fall sharply in its first two or three years of retirement is forced to sell a larger proportion of units at those depressed prices to fund the same fixed withdrawal amount. This permanently reduces the remaining unit count available to eventually benefit from the market's later recovery, in a way that a bad early stretch during the earlier accumulation phase, with no withdrawals happening yet, simply does not.

This article extends the introductory treatment of sequence risk in the portfolio construction section. The core insight bears repeating and deepening: the order in which returns occur matters as much as the average return, particularly during the decumulation (withdrawal) phase. Two retirement portfolios experiencing the same set of annual returns in different orders can have wildly different longevity outcomes.

Consider two 25-year retirement scenarios with the same average annual return of 8%. In Scenario A, the first five years deliver -15%, -10%, 5%, -5%, 0%, followed by 20 years averaging 12%. In Scenario B, the first five years deliver 15%, 20%, 12%, 18%, 10%, followed by 20 years averaging 4%. Both average 8% over 25 years. But Scenario A, with poor early returns during active withdrawal, exhausts the portfolio in year 18. Scenario B sustains withdrawals for the full 25 years because the strong early returns built a large enough base to absorb the weaker later years.

Why the first several years carry disproportionate weight

The mathematics of this risk mean that returns experienced during roughly the first five to ten years after retirement withdrawals actually begin have a disproportionately large influence on whether a retirement corpus ultimately lasts through its full intended duration, compared to returns experienced in later years of that same retirement.

The mitigation strategies fall into three categories. First, reducing equity allocation in the years immediately before and after retirement (the "glide path" approach) limits the portfolio's exposure to a sharp drawdown during the most vulnerable period. Second, maintaining a cash or short-duration debt buffer covering 2-3 years of withdrawals ensures that equity does not need to be sold during downturns. Third, flexibility in withdrawal amounts (reducing spending during poor markets, increasing during good markets) dramatically improves portfolio longevity compared to rigid fixed withdrawals.

Practical ways to manage this specific risk

Holding a cash or short duration buffer covering a couple of years of planned withdrawals, so that equity holdings are not forced to be sold during an early downturn, and being willing to flexibly reduce withdrawals temporarily during a market decline rather than sticking to a rigid fixed amount, are both commonly used, practical ways to manage this specific concentrated risk.