Retire · 5 min read
Sequence-of-returns risk in plain words
Why the order of market returns matters most in the first years of retirement, and how buffer assets help you avoid selling low.
Sequence-of-returns risk in plain words
Why the order of market returns matters most in the first years of retirement, and how buffer assets help you avoid selling low.
Pillar: Retire · Reading time: 5 min
In plain words
While you are saving, the order of good and bad years matters less than you might think. If you never withdraw, a 20% fall followed by a 25% rise ends in the same place as the rise followed by the fall.
Once you start taking income, the order matters a lot. A big fall early in retirement, while you are also withdrawing, means you sell more shares at low prices to pay the bills. Those shares are gone, so they cannot recover when the market does. Planners call this sequence-of-returns risk.
The danger zone is usually the five years before and the ten years after retirement, when your balance is at its largest and withdrawals begin.
A simple way to see it
Picture two retirees with the same savings, the same withdrawals and the same average return over 20 years. The only difference is the order of the returns. One gets the bad years first; the other gets them last. The first can run out of money years earlier. Same average, very different outcome.
Why the wealthy worry less
Wealthy families seldom need to sell investments in a downturn. They have other money to live on: income from a business, rents, bonds, or cash reserves. They wait for markets to recover before selling. The tools below give an ordinary household the same patience.
Ways to manage it
Cover essentials with steady income
An income floor of Social Security, a pension and, if it fits, an income annuity pays essential bills whatever markets do. Then the portfolio only funds wants, and you can cut back in a bad year.
Keep buffer assets
A buffer asset is money outside the market that you draw from in down years instead of selling stocks. Common buffers:
- A cash reserve. One to three years of planned withdrawals in high-yield savings, money market funds or short-term Treasuries.
- A bond ladder. Bonds that mature year by year, each covering one year of spending.
- Cash value life insurance. If a permanent policy is already part of the plan, its cash value is not tied to the market and can be accessed through withdrawals or policy loans in down years, then left alone in up years. Loans reduce the death benefit and charge interest, and a policy must stay in force, so this works only as part of a designed plan.
- A home equity line of credit. Some retirees keep one open as a reserve, though lenders can reduce or freeze lines in a downturn.
The rule is simple: in a year after the market falls, spend from the buffer. In a year after it rises, spend from the portfolio and refill the buffer.
Adjust withdrawals
Flexible spending rules, such as skipping inflation increases after a loss year, cut the damage. Even a small cut in the worst years can extend how long savings last.
Reduce risk near the retirement date
Some plans lower the share of stocks in the years around retirement, then gradually raise it again as the danger zone passes. Planners call this a rising equity glide path.
A worked example (illustrative)
Paula and Sam each retire at 65 with $1,000,000 and withdraw $50,000 a year, rising with inflation. Both earn the same average return over 25 years. Paula's portfolio falls 25% in year one and 10% in year two. Sam's falls by the same amounts in years 24 and 25.
| Paula (bad years first) | Sam (bad years last) | |
|---|---|---|
| Balance after year 2 | about $595,000 | about $1,030,000 |
| Age money runs out (illustrative) | about 85 | still about $900,000 at 90 |
Now suppose Paula had kept $100,000 of her $1,000,000, two years of withdrawals, in a cash buffer. In years one and two she spends the buffer and sells no stocks at the bottom. Her invested balance after year two is about $607,000, a little higher than before, but the real gain comes next: every share is still there for the recovery, and in this illustration her money lasts about four years longer. These numbers are simplified and illustrative only, not a projection.
Common mistakes
- Relying on average returns. Averages hide order. Plan for a bad first five years.
- Keeping no buffer. Without one, every down-year withdrawal is a forced sale.
- Holding too much in cash for too long. A buffer that is too large can lose to inflation. Size it to a few years of withdrawals.
- Panic selling. Moving everything to cash after a fall locks in the loss.
- Forgetting to refill. A buffer only works if it is topped up in good years.
FAQs
Does sequence risk matter before retirement?
Most in the five years before, because a large loss then leaves less time to recover and shrinks the balance you start retirement with.
Is the 4% rule enough protection?
It was built from historical returns, including bad sequences, but it is a guideline, not a guarantee. A floor, a buffer and flexible spending add protection.
How big should a cash buffer be?
Many plans use one to three years of planned portfolio withdrawals, not of total spending, because Social Security and pensions keep paying.
Can annuities help?
Yes. An income annuity covers part of spending for life, which reduces how much you need to withdraw from the portfolio in any year. It also gives up access to the money used.
Is cash value a good buffer?
It can be, if the policy already fits your protection plan and is well funded. It is not a reason by itself to buy a policy.
Related strategies
- The income floor: covering essentials for life — take essentials off the market.
- Annuity types compared: SPIA, DIA, FIA and MYGA — tools for steady income.
- Emergency funds that earn — where reserve money can sit.
Next step
Take the Wealth Strategy Score at /score to see whether your retirement plan has a floor and a buffer in place.
Education only, not personal financial, tax, legal or insurance advice. VeraLife.ai is not a registered investment adviser, broker-dealer or insurance agency. All numbers are illustrative.