Sequence of returns risk is one of the most significant but least understood threats to retirement security. While average returns matter during your accumulation years, the order of returns becomes critical once you start withdrawing from your portfolio. Poor returns early in retirement can permanently damage your portfolio, even if markets recover later. This guide explains sequence risk and strategies to protect your retirement savings.
In This Article
1What Is Sequence of Returns Risk
Sequence of returns risk refers to the danger that negative investment returns early in retirement will deplete your portfolio faster than expected, even if long-term average returns are acceptable. When you are withdrawing money, losses early on mean you are selling more shares at low prices, leaving fewer shares to benefit from eventual recovery. Two retirees with identical average returns but different sequences can have dramatically different outcomes – one might run out of money while the other has plenty.
2Why Early Retirement Years Are Critical
The first 5-10 years of retirement are the most vulnerable to sequence risk. During this period, your portfolio is at its largest, and withdrawals combined with poor returns can create a downward spiral. If you retire into a bear market and continue withdrawing 4% annually, your portfolio may never recover even when markets rebound. Conversely, strong early returns provide a cushion that can sustain your portfolio through later downturns. This is why retirement timing and early-year strategies are so important.
3Strategies to Mitigate Sequence Risk
Several strategies can help protect against sequence risk. Maintain a cash reserve covering 1-2 years of expenses to avoid selling investments during downturns. Consider a more conservative allocation in the years immediately before and after retirement – the retirement red zone. Use a flexible withdrawal strategy that reduces spending during market downturns. Delay Social Security to provide higher guaranteed income later. Consider partial annuitization to create a floor of guaranteed income that does not depend on market performance.
4The Bucket Strategy for Sequence Protection
The bucket strategy specifically addresses sequence risk by segmenting your portfolio by time horizon. Keep 1-2 years of expenses in cash or short-term bonds (Bucket 1), 3-7 years in intermediate bonds (Bucket 2), and the remainder in stocks for long-term growth (Bucket 3). Spend from Bucket 1 during market downturns, giving your stock investments time to recover. Replenish Bucket 1 from Bucket 2 or 3 during favorable markets. This approach provides both psychological comfort and practical protection.
5Flexible Spending as a Defense
One of the most effective defenses against sequence risk is spending flexibility. If you can reduce discretionary spending by 10-20% during market downturns, you dramatically improve your portfolios survival odds. Identify which expenses are truly essential versus discretionary. Build a retirement budget with a baseline of essential expenses and a cushion of flexible spending that can be adjusted based on portfolio performance. This flexibility can be the difference between running out of money and a secure retirement.
Key Takeaways
- Poor returns early in retirement can permanently damage your portfolio
- The first 5-10 years of retirement are most vulnerable to sequence risk
- Maintain 1-2 years of expenses in cash to avoid selling during downturns
- The bucket strategy provides structured protection against sequence risk
- Spending flexibility is one of the most effective defenses
Conclusion
Sequence of returns risk is a real threat that can derail even well-planned retirees. By understanding this risk and implementing protective strategies – cash reserves, conservative early-retirement allocations, flexible spending, and guaranteed income sources – you can significantly improve your odds of a successful retirement regardless of market conditions in your early retirement years.