Sequence-of-Returns Risk: Why the Order of Returns Matters Once You Start Withdrawing

While you are saving, the order of investment returns doesn't change where you end up. A bad year early and a good year late produce the same final balance as a good year early and a bad year late, as long as you aren't adding or removing money. Multiplication doesn't care about order.

Once you start withdrawing, that stops being true. A market drop in the first few years of retirement can do lasting damage, even if returns are strong afterward. This is called sequence-of-returns risk, and it is one of the most important and least understood risks in retirement planning.

The short version

• Without withdrawals, the order of returns has no effect on the ending balance.
• With withdrawals, losses early on force you to sell more of a shrunken portfolio, leaving less to recover when markets rebound.
• In our example, two retirees earn the same 25 annual returns, just in reverse order, and withdraw the same $50,000 a year. One ends with about $471,000. The other ends with about $2.1 million.
• The riskiest period is roughly the five years before and after retirement begins.
• Common ways to manage it include cash buffers, flexible spending, and adjusting asset allocation, each with trade-offs.

The experiment

Two hypothetical retirees each start with $1,000,000. Each withdraws $50,000 at the start of every year for 25 years. Both earn exactly the same set of 25 annual returns, which average about 6.6% a year (about 6.35% compounded). The only difference:

• Retiree A gets the bad years first: −20%, −10%, −5% in years one through three, then mostly positive returns.
• Retiree B gets the identical returns in reverse, so the three bad years land at the very end.

These returns are made up for illustration and are not a forecast.

After three years, Retiree A is down to about $560,000. The subsequent good years are working on a much smaller base, and the $50,000 withdrawals are now a much larger share of the portfolio. Retiree A never recovers. Retiree B, meanwhile, grows the portfolio for two decades and still ends with over $2.1 million even after three bad years at the end.

Now remove the withdrawals and run the same two sequences:

Identical. The withdrawals create the risk.

Why withdrawals change everything

When a portfolio falls 20% and you withdraw the same dollar amount, you are selling a larger share of your holdings to raise that cash, often at low prices. Those shares are gone. When the market recovers, there are fewer shares to benefit.

Each early loss raises the effective withdrawal rate, and a higher withdrawal rate leaves less room to recover. This is why the first several years of retirement matter so much more than later years.

The danger zone

The risk is greatest in the years right around retirement:

• Just before retirement, a large loss can reduce the nest egg right when contributions are ending.
• Just after retirement, withdrawals begin and losses compound with them.

Planners often call this the retirement red zone, usually described as about five years on either side of the retirement date. A loss at age 40 is a setback with decades to recover; the same loss at 66, with withdrawals running, can permanently lower what the portfolio can support.

Ways people manage sequence risk

Each approach has costs. None eliminates the risk entirely.

Cash or short-term bond buffer. Keeping one to three years of planned withdrawals in cash or short-term bonds lets you avoid selling stocks during a downturn. The cost is lower expected returns on the buffer.

Flexible withdrawals. Spending less after a bad year, or skipping inflation increases, reduces pressure on the portfolio. Even modest flexibility can help a lot. The cost is a less predictable income.

Guardrail rules. Some retirees set rules in advance: cut spending by a set amount if the withdrawal rate rises above a threshold, raise it if the portfolio grows well. This makes the flexibility automatic.

Asset allocation around retirement. Some people reduce stock exposure in the years near retirement and gradually increase it later, sometimes called a rising equity glide path. Others hold steady. The right mix depends on risk tolerance and other income.

Guaranteed income. Social Security, pensions, and income annuities cover part of spending regardless of markets, which reduces how much the portfolio must provide. Delaying Social Security, where feasible, raises guaranteed income later. Annuities come with costs and trade-offs worth understanding fully before buying.

Part-time work or delayed retirement. Even a few years of earned income near retirement can let the portfolio grow or avoid early withdrawals.

Sequence risk and the "average return" trap

Many retirement projections assume a steady average return every year. That hides sequence risk completely. Two retirements with the same average return can end very differently, as the example shows. Planning tools that run many possible return sequences, often called Monte Carlo simulations, try to show the range of outcomes instead of a single line. They are useful for understanding risk, though results depend heavily on their assumptions.

The takeaway

The order of returns doesn't matter while you're only saving, and matters enormously once you start withdrawing. The years right around retirement carry the most risk. Cash buffers, spending flexibility, thoughtful allocation, and guaranteed income sources are the main tools for managing it. A financial planner can model how these would work with your actual savings and income.