Sequence of Returns Risk: Protect Your Retirement Income

The smiling sun hits your well-rested face. After decades of working, you finally retired a few months ago. 

You wake up at 10 am each day, and you’re not late for anything. You have $700,000 in your brokerage account and you feel amazing.

You sit down to eat your breakfast and then your stock app beeps.  The stock market is down by 2% for the day. 

“No problem.”

However, it doesn’t stop there.  The red stock quotes fill your computer screen for months, and then the months eventually turn into a couple of years. 

Your retirement portfolio now sits at $440,000, just over two years into retirement.  The stock market is getting hammered and you still have to withdraw your $30,000 to pay your yearly expenses.    

Your retirement life is now filled with stress and despair.  Are you going to run out of money?

The above scenario is a common worry for retirees, though it rarely occurs.

This is called sequence of returns risk and we will go over what it is, why it can be so harmful and then go over a few tips that can help mitigate this risk and allow you to reduce financial stress in retirement.

What Does Sequence Of Returns Risk Mean?

Sequence of returns risk is the risk that you will experience several years of negative returns at the start of your retirement. This will significantly impact your retirement balance throughout your lifetime.

The order of your investment returns can severely harm or boost your retirement balance when combined with yearly withdrawals. 

If you have saved and invested your hard-earned money for decades, you don’t want to see it fritter away quickly because of a bear market at the beginning of your retirement. 

If the market performs poorly as soon as you retire, then you could be in for a rough ride simply because you are also withdrawing funds to cover your everyday living expenses while your equities are tumbling in value. 

The subtle element of withdrawals makes sequence risk an enormous factor in the retirement phase of your life and a non-factor during the accumulation phase of your life. 

In the accumulation phase of your life, you build up your retirement nest egg.  Let’s see how that looks.

Accumulation Phase Order of Returns

When you are accumulating assets from your twenties to your early sixties, the stock market could have a crash in year 1, 10 or year 15 and it wouldn’t matter as much to you. 

The lean years could occur early on, in the middle or right before you start retirement, and your portfolio will end with the same balance because you aren’t withdrawing money.

Suppose you have $100,000 invested in year 1.  The next year the market crashes by 20%, and then again another 10% in year two before bouncing back by 50% in year three. 

You would have $108,000 after three years in your account (Scenario A).  

A BalanceA ReturnsB BalanceB Returns
Opening Balance$100,000 $100,000 
Year 1$  80,000-20%$ 150,000 50%
Year 2$  72,000-10%$ 135,000-10%
Year 3$ 108,000 50%$ 108,000-20%

For Scenario B, imagine you have the same $100,000.  If the market returns were instead a gain of 50% in year 1, a drop of 10% in year 2, and a drop of 20% in year 3, you would end up with…..the same $108,000.

In both cases, the stock market made the same yearly returns just in reverse order.  Yet you still end up with the same final balance.  When you are investing and keeping money in your investment accounts, the order of returns has no effect on your ending portfolio balance.

In retirement, that is no longer the case, because you are also withdrawing money.  You still need to sell your assets to cover your daily expenses, whether the stock market has a good year or a poor year. This one simple change leaves you exposed to experiencing sequence risk. 

If the stock market performs poorly at the beginning of your retirement, it can greatly affect your final retirement balance negatively. 

If the stock market performs wonderfully at the beginning of your retirement, you may never run out of money and also have a substantial nest egg to leave to your heirs. 

Retirement Phase Order of Returns

Table 1.1 shows how your retirement account would fluctuate over a 20-year period under three different scenarios, all with 4% withdrawal strategies and no inflation.    

Each year you withdraw 4% of $300,000, which is $12,000, on January 1st.

There are three scenarios listed below, and each produces an overall average return of 6% per year over 20 years.  The difference lies in the order of year-to-year returns. 

Scenario A (AVG)

The first scenario has a stock market return of 6% per year, every year.  You end up with an account balance of $494,228 despite withdrawing $240,000 over the 20 years and only starting with $300,000.  That’s the power of compounding, even when withdrawing money.

This is a highly unrealistic scenario, as the markets do not post the same returns in consecutive years. 

Scenarios 2 and 3 (labelled NEG and POS – for Negative and Positive) represent a typical up and down stock market ride that a real life investor would typically face. 

Remember, each one of the three scenarios has a 6% return overall average, which makes you think the final portfolio balance should be the same for all scenarios.  If you were in the accumulation stage and not withdrawing or depositing any money, that thinking would hold true.

However, when you are in retirement and making yearly withdrawals, the difference can be staggering.  This is to illustrate the effect that sequence risk can have on your retirement portfolio.

Table 1.1

YearReturn (AVG)End Balance (AVG)Return (NEG)End Balance (NEG)Return (POS)End Balance (POS)
16%$ 305,280-11%$ 256,32029%$ 371,520
26%$ 310,877-13%$ 212,558-6%$ 337,949
36%$ 316,809-25%$150,41920%$ 391,139
46%$ 323,09829%$178,56010%$ 417,052
56%$ 329,7649%$ 181,551-1%$ 401,002
66%$ 336,8307%$ 181,41912%$ 435,682
76%$ 344,31916%$ 196,52630%$ 550,787
86%$ 352,2594%$ 191,90714%$ 614,217
96%$ 360,674-37%$ 113,3420%$ 602,217
106%$ 369,59522%$ 123,63711%$ 655,141
116%$ 379,05011%$ 123,91722%$ 784,632
126%$ 389,0730%$ 111,917-37%$ 486,758
136%$ 399,69814%$ 113,9054%$ 493,748
146%$ 410,96030%$ 132,47716%$ 558,828
156%$ 422,89712%$ 134,9347%$ 585,106
166%$ 435,551-1%$ 121,7059%$ 624,686
176%$ 448,96410%$120,67529%$ 790,364
186%$ 463,18220%$ 130,410-25%$ 583,773
196%$ 478,253-6%$ 111,305-13%$ 497,443
206%$ 494,22829%$ 128,104-11%$ 432,044

Scenario B (NEG)

In Scenario NEG you can see that there are three consecutive negative return years (-11%, -13% and -25%) at the beginning of your retirement, followed by a huge positive (29%) return in the fourth year.

However, the first three years of negative returns combined with the withdrawals of $36,000 leave you with only half your original account balance ($150,419) after only three years.  The effect of your portfolio’s dismal start remains throughout your entire twenty-year retirement period and you end up with only $128,104.   That is just a little over one quarter of the amount you end up with in scenario A ($494,228). 

Scenario C (POS)

In Scenario POS, the yearly returns are reversed from Scenario NEG.  For example, in years 18, 19 and 20 of Scenario NEG you earned 20%, -6% and 29% respectively on your investments. 

Now for Scenario POS, those same returns become the first three rates of return at 29% in year 1, -6% in year 2 and 20% in year 3. 

After three years in this scenario, your account balance is $391,139 and this positive balance carries on throughout the rest of your twenty-year retirement period.  You end up with $432,044 in your account.  That figure is much closer to the final balance in Scenario A of $494,228, and it is 3.37 times higher than $128,104 value that the NEG scenario left you with. 

Takeaways from Sequence Risk Scenarios

In all scenarios, the following factors were the same:

  • Withdrawals occurred on Jan 1st each year.
  • The starting balance was $300,000 before the first withdrawal and first returns were experienced.
  • You withdrew a constant $12,000 (4%) of your portfolio each year.
  • Inflation was not considered.
  • The average return for the overall 20-year period was the same (6% – which also matches the AVG Scenario 1 as well.

The only difference was the order (sequence) of returns.  In these scenarios, the difference was stark between the positive (POS) $432,044 and negative (NEG) $128,104 scenarios.  That’s a difference of $303,840.  

3 Tips to Soften the Sequence of Returns Effect

There are a few ways you can dampen the effects of sequence risk.  They are to:

  • Build a stockpile of cash or savings
  • Increase your guaranteed income streams
  • Change your asset allocation
Mitigate sequence of returns risk

1. Build a Stockpile of Cash or Savings

You can build up a substantial cash position to fund anywhere from one to four years of retirement expenses that are not covered by the Canadian Pension Plan (CPP) or Old Age Security (OAS).  If you experience a bear market upon retiring, then you can stay fully invested in the markets and only withdraw money for living expenses from your cash or high-interest savings accounts.

You need to create a retirement budget first so that you know how much of your retirement lifestyle is going to be covered by your CPP or OAS benefit payments. 

Now, suppose you have $15,000 of expenses per year that are not covered by CPP or OAS.  You can stash anywhere from $15,000 to $60,000 away in savings or Guaranteed Income Certificates (GICs) depending on if you want to cover one, two, three or four years’ worth of living expenses.

If there is a market crash and you had a cash/savings account of $60,000, you would not even need to sell anything out of your investment accounts at low values to produce income. 

Your cash/savings accounts would cover all your outstanding basic expenses.  This gives your investments a few years to bounce back and return to their original values.  At that point, you could sell a portion of your investments at higher prices and produce more income.

2. Bolster Your Guaranteed Income Streams

CPP and OAS benefits are guaranteed for life and indexed against inflation.  That means any payments you receive from these two benefits will provide you with worry-free returns.  You can depend on your CPP and OAS direct deposits being there for you every month. 

Having these guaranteed income streams lowers your reliance on the stock market to produce high enough returns to fund your retirement lifestyle.  In fact, if your guaranteed income streams like CPP and OAS cover all your expenses in retirement, then the stock market can do whatever it wants and it won’t affect you. 

If you have a substantial retirement portfolio balance, you might consider adding an annuity to your portfolio mix to create another guaranteed income stream. 

An annuity is a huge lump sum cost, but you receive a monthly payout that is guaranteed for life in return.  This lessens your exposure to investment and sequence risk.

3. Change Your Asset Allocation

If you had a 100% equity portfolio in your accumulation stage and you have a huge fear of sequence risk, you should alter your asset allocation

You may decide to be defensive and adjust your portfolio down to a 50% equities / 50% bonds allocation for the first five years of retirement. 

If the stock market crashes by 30% in that timeframe, your 50/50 portfolio would only drop 15% if bond values do not fall.  You would lose out on gains if the market did well, but you dampen the effects of sequence risk.  Then you could shift your bond allocations back over to equities when you felt comfortable. 

Why Use a Constant Withdrawal Rate?

One of the main pushbacks to any constant withdrawal rate strategy is that constant withdrawals are not realistic.

Think about your yearly budget and how much your spending fluctuates from year to year. 

One year, you might spend $50,000.  The next year?  Maybe you spend $60,000 or $42,000.  It really depends on what is going on in your personal life. 

Studies have concluded that retirement spending declines in your early seventies.  Not only that, but the spending continues at that reduced rate for the rest of your life.   

People are also very adaptable to new situations.  If you are a retiree and notice that your retirement account is dwindling away to a level where you need to be worried, you would adjust. You would cut all discretionary spending if you had to in order to make ends meet.

An alternative withdrawal method is to bump up your withdrawal rates in years where the markets provide extra returns and cut back on the total amount you withdraw in the lean years where the market declines. 

In years where the stock market return is 10% + for instance, withdraw 5% or even 6% of your original retirement account value and let it sit as cash or in a short-term GIC to help fund the years when stock market returns are negative. 

Sequence of Returns Risk Conclusion

In retirement, the order of stock market returns from year to year can have a substantial effect on your portfolio.  If a bear market greets you in the first year of retirement, it can be scary.

However, you can use strategies such as weighting your portfolio more towards fixed income in the first few years.  Or you can have 1-4 years’ worth of cash on hand to pay for your expenses while your investments try to regain their former value.  Or you can purchase an annuity. 

There are ways to strategically minimize the impact that sequence risk has on your retirement portfolio.  You simply need to prepare your portfolio ahead of retirement so it does not catch you off guard.

Which strategies have you used or will you plan on using in the future to avoid sequence of returns risk? Let us know in the comment section below.

Sequence of Returns Risk FAQs

How can sequence of returns risk be avoided?

Sequence of returns risk can be avoided by stockpiling cash in savings accounts (known as the bucket strategy), increasing your guaranteed income streams (deferring OAS/CPP or taking out an annuity) and changing your asset allocation closer to retirement (reduce equity exposure and increased fixed-income holdings).

What is sequencing risk?

Sequencing risk is the risk that a bear market devastates your retirement investment portfolio while you also withdraw your money from it. This “double whammy” of lower values and withdrawals negatively impacts your retirement fund to a great extent.

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