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Sequence of Returns Risk – How It Can Make or Break Your Retirement

Every day, roughly 10,000 American baby boomers reach retirement age. But are they financially ready for retirement?

According to data compiled by Comet Financial Intelligence, a shocking 42% of baby boomers have nothing – that’s $0 – saved for retirement. And if they’re counting on Social Security to cover their expenses, they’re in for a rude awakening; Social Security pays an average monthly benefit of $1,413. But beyond the obvious retirement mistake of not saving enough, the greatest retirement risk for Americans without a nest egg is sequence risk.

If you’re wondering why you’ve never heard this term, it’s because it’s counterintuitive and few people talk about it outside financial planning circles. Yet preparing for sequence risk can make or break your nest egg in retirement.

What Is Sequence Risk?

Sequence risk, or sequence of returns risk, is the risk that the stock market crashes early in your retirement.

Why does this matter, you may ask? After all, over the long term, equity returns average out to 7% to 10%, right?

It turns out that for retirees, long-term average returns matter less than when those returns occur. If a portfolio has a decade or so of positive gains, it reaches a critical mass where it can withstand simultaneous losses from withdrawals and price dips.

However, when you’re only selling stocks, not buying them, a crash is all downside for you. Your portfolio drops dramatically in value, and you end up selling low without the ability to gain by buying low. You also have to sell more of your stocks to generate the same amount of income, which means you’re selling off your nest egg shares at a faster rate.

Sequence Risk & Safe Withdrawal Rates

How much can you safely withdraw from your nest egg every year? It depends on how long you want your nest egg to last, as well as the returns in the first decade of your retirement.

Many financial experts recommend following the 4% rule when it comes to retirement withdrawal rates. The concept is simple: If you withdraw no more than 4% of your nest egg every year, it should last for at least 30 years. In other words, 4% is a safe rate at which to withdraw money from your portfolio for a 30-year retirement.

Imagine you have $1 million set aside for retirement, and you need to sell off $40,000 for your living expenses in the first year of retirement. In a moderate year with, say, a 7% increase in stock market values, your portfolio rises in value to $1,070,000. You sell off $40,000 to live on, and your portfolio ends the year at $1,030,000.

But what if, instead, the market crashes by 30% in your first year of retirement? Your portfolio drops to $700,000. That means the $40,000 you’re withdrawing is a much larger percentage of your portfolio – 5.7% instead of 4%. Now you’re down to a nest egg of $660,000.

For you to recover to your initial $1 million nest egg in the next year, the stock market would need to rise by 52% before you take next year’s living expenses out of it. By the time the recovery hits, your portfolio will have seen massive losses because you’ve been selling so many stocks to produce the same amount of income. You don’t get to buy the dip; all you can do is sell it for losses.

An Example of Sequence Risk

Say you retired on January 1, 2000 with $1 million invested in an index fund that tracks the S&P 500. Assume you followed the 4% rule and withdrew $40,000 in your first year of retirement, then adjusted the withdrawal upward by 2% every year to account for inflation. How would your nest egg perform over the next 15 years?

As you probably know, 2000 to 2015 wasn’t a stellar stretch for U.S. stocks. The dotcom bubble burst in 2000, causing three terrible years in a row. Then, in 2008, the Great Recession hit. The average annual return on the S&P 500 from 2000 to 2014 was 4.07%, not adjusting for inflation.

But imagine if the three terrible years from 2000 to 2002 took place at the very end of the 15-year period, rather than the beginning. If you swapped the returns from 2000 to 2002 with the returns from 2012 to 2014, how would it affect your retirement portfolio?

Dramatically, as it turns out. Simply by swapping when those returns occurred, your ending portfolio balance in 2014 would be over three times higher – $890,871 instead of a measly $273,438.

Here’s how the numbers play out over 15 years in both scenarios:

Year Withdrawal Return (Actual)
Portfolio Balance Return (Swapped)
Portfolio Balance
2000 $40,000.00 -10.14% $858,600.00 13.41% $1,094,100.00
2001 $40,800.00 -13.04% $705,838.56 29.6% $1,377,153.60
2002 $41,616.00 -23.37% $499,268.09 11.39% $1,492,395.40
2003 $42,448.32 26.38% $588,526.69 26.38% $1,843,640.98
2004 $43,297.29 8.99% $598,137.95 8.99% $1,966,087.02
2005 $44,163.23 3% $571,918.86 3% $1,980,906.40
2006 $45,046.50 13.62% $604,767.71 13.62% $2,205,659.35
2007 $45,947.43 3.53% $580,168.59 3.53% $2,237,571.70
2008 $46,866.38 -38.49% $309,995.32 -38.49% $1,329,463.98
2009 $47,803.70 23.45% $334,885.52 23.45% $1,593,419.58
2010 $48,759.78 12.78% $328,924.11 12.78% $1,748,298.82
2011 $49,734.97 0% $279,189.14 0% $1,698,563.85
2012 $50,729.67 13.41% $265,898.73 -10.14% $1,475,599.80
2013 $51,744.27 29.6% $292,860.49 -13.04% $1,231,437.32
2014 $52,779.15 11.39% $273,438.15 -23.37% $890,871.27
Average Return: 4.07% 4.07%


In both scenarios, the average annual returns are the same. The only difference is the order of those returns.

Sequence Risk at a Higher Withdrawal Rate

The higher the withdrawal rate, the higher the sequence risk.

To demonstrate the relationship between sequence risk and withdrawal rate, imagine two identical twins, each of whom retires at the beginning of 2000. They each follow the same investing formula as above: a $1 million nest egg invested in a fund tracking the S&P 500.

Higher Rates Arrow Graph Chart

One twin withdraws a conservative 3.5% each year, while the other lives large on a 5% withdrawal rate. Here’s how the higher withdrawal rate changes the portfolio performance:

Year Return
3.5% Withdrawal Rate Portfolio Value 5% Withdrawal Rate Portfolio Value
2000 -10.14% $35,000.00 $863,600.00 $50,000.00 $848,600.00
2001 -13.04% $35,700.00 $715,286.56 $51,000.00 $686,942.56
2002 -23.37% $36,414.00 $511,710.09 $52,020.00 $474,384.08
2003 26.38% $37,142.28 $609,556.93 $53,060.40 $546,466.21
2004 8.99% $37,885.13 $626,470.98 $54,121.61 $541,471.91
2005 3% $38,642.83 $606,622.28 $55,204.04 $502,512.03
2006 13.62% $39,415.68 $649,828.55 $56,308.12 $514,646.04
2007 3.53% $40,204.00 $632,563.50 $57,434.28 $475,378.76
2008 -38.49% $41,008.08 $348,081.73 $58,582.97 $233,822.51
2009 23.45% $41,828.24 $387,878.65 $59,754.63 $228,899.26
2010 12.78% $42,664.80 $394,784.74 $60,949.72 $197,202.86
2011 0% $43,518.10 $351,266.64 $62,168.72 $135,034.15
2012 13.41% $44,388.46 $353,983.03 $63,412.09 $89,730.14
2013 29.6% $45,276.23 $413,485.78 $64,680.33 $51,609.93
2014 11.39% $46,181.76 $414,400.05 $65,973.94 ($8,485.64)


At a 3.5% withdrawal rate, the more frugal twin still has $414,400 in their portfolio by the end of 2014. The big spender ran out of money, a doomsday event in retirement planning.

Clearly, your spending in retirement has an enormous impact on the risk of your portfolio going belly up before you do. But besides lowering their withdrawal rate, what else can new retirees do to protect against sequence risk?

Ways to Mitigate Sequence Risk

Nobody knows when the next stock market crash will hit. It could come tomorrow, or it could be many years away. However, while you don’t have control over the stock market, you can still make sure you’re prepared for a market crash early in your retirement by doing the following.

1. Continue Working Part-Time

Retiring from your full-pay, full-stress, full-time job doesn’t mean you have to stop working entirely. You could keep working part-time on your own schedule, or work full-time doing something different that you love.

There are plenty of good reasons to keep working after you retire. You stay engaged. You stay in touch with your work-related social life and connections. Perhaps you can even keep your health insurance.

Financially, working during retirement provides another source of income, leaving you less dependent on your nest egg. If the stock market crashes, you can lean on the income from your job instead of selling off stocks while they’re at fire-sale prices.

2. Diversify Your Investment Income

Remember, the example numbers above assumed 100% of your retirement funds were invested in a fund tracking the S&P 500. That’s hardly a diverse portfolio.

In financial planner William Bengen’s research, from which he formulated the 4% rule, he ran his numbers with a 60/40 equities-bonds allocation. His sample portfolios were split between 60% following the S&P 500 and 40% invested in intermediate-term U.S. government bonds.

Even among stocks, investors can diversify into a blend of small-, mid-, and large-cap funds. You don’t have to invest only in U.S. funds, either. Instead, try investing in a mix of U.S. and international funds.

And your investment options don’t end with stocks and bonds. You can invest in rental properties, private notes, real estate investment trusts (REITs), private equity funds, or crowdfunding websites. Other options include annuities, which insure against outliving your nest egg, and bonds.

3. Create a Bond Ladder

Sequence risk is the risk of a major market crash in the first few years of retirement. So, why not ensure income from sources other than equities during that vulnerable period?

Working is a great option, but it’s not the only one. Another option for low-risk income early in retirement is a bond ladder. It sounds technical and complicated, but it’s not. A bond ladder is simply a series of bonds bought strategically so that each set reaches maturity at a different time and you get your principal back in a successive series.

For example, instead of investing $100,000 in the same set of bonds all scheduled to mature in 10 years, you invest $10,000 in 10 different sets of bonds. The key is that each set should be scheduled to mature at a different year over the next 10 years.

In addition to the interest, you’ll receive $10,000 back every year for the next 10 years. If the stock market is doing well, you can re-invest the principal or set it aside in cash. In the event of a stock market crash, you can live on the bond principal rather than having to sell off equities at low prices.

4. Be Flexible With Your Spending

One way to protect against sequence risk is staying agile so you can slash your spending on command. If the stock market crashes 30% the year after you retire, you want to sell as few stocks as possible during the crash.

If you had to, could you live solely on your other sources of income, such as bonds, rental properties, and Social Security?

Even during plush years of strong stock market gains, if you can spend less in the first few years of retirement and minimize withdrawals from your equities, you’ll be in a stronger position when a crash hits. Review your fixed and variable expenses and look for ways to trim spending and live more frugally in the first few years of retirement.

5. Keep a Cash Reserve

Early in your retirement, you may want to keep a larger emergency fund than usual. If the worst happens and your portfolio is hit by a market crash, you can live on your cash savings rather than sell during the crash.

Granted, keeping money in cash comes with an opportunity cost; it sits idle, losing value to inflation instead of working hard for you. But the peace of mind may be worth it in the critical first few years of retirement.

6. Have Affordable Backup Fund Sources

By the time they retire, many Americans have built substantial equity in their homes. If needed, they could draw on that equity to see them through a stock market crash.

One option is a home equity line of credit (HELOC). Homeowners can have the line in place, unused, in the event of an emergency. They can then draw on it as needed to minimize withdrawals during a stock market crash.

A second option is a reverse mortgage. While reverse mortgages come with their own drawbacks, they can add another source of income to see you through a stock market collapse.

Final Word

As you plan and prepare for your retirement, simply being aware of sequence risk puts you ahead of the crowd.

While you’re still working, take advantage of tax-protected retirement accounts, such as 401ks and IRAs. The less money you lose to taxes, the faster your nest egg will grow. If you’re eligible, push those tax advantages even further with the saver’s tax credit.

With each year of positive stock market returns in retirement, your portfolio becomes less susceptible to sequence risk. Eventually, it reaches a critical mass where ordinary recessions and bear markets pose virtually no threat as long as you maintain your safe withdrawal rate.

Speak with a retirement advisor for personalized advice about your finances and situation. With enough spending flexibility and other sources of income, you’ll be able to sleep soundly at night no matter how wildly the stock market fluctuates.

Have you discussed sequence risk with an advisor? What did they recommend to you?

G. Brian Davis
G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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