February 21, 2025

Understanding Sequence Risk: A Hidden Threat to Your Retirement Portfolio

As an investor, your focus is often on what to buy, when. As you enter retirement, however, this focus shifts to become what to withdraw, when. For your portfolio returns, the timing of your returns plays a role in the maximum returns you could experience from your portfolio. By understanding how scheduling withdrawals can impact the long-term value of your portfolio, you can identify ways to optimize the potential for growth, even as you begin with withdraw.

This involves mitigating sequence risk – a critical, yet often overlooked, factor that can significantly impact retirees and those nearing retirement.

What Is Sequence Risk?

Sequence risk refers to how the order and timing of investment returns can negatively impact your portfolio, particularly during the withdrawal phase of retirement. If you withdraw money early into retirement in a bear market, you are removing the opportunity for those lower-value assets to grow back as the market recovers. In contrast, if you withdraw early during a bull market, you don't need to sell as many securities to cover your expenses. Even with the same average return over time, investors assets can deplete much earlier and rapidly if they make withdrawals early into retirement when the market is experiencing a downturn.

Why Does Sequence Risk Matter?

It is important to pay attention to sequence risk in order to understand how to optimize the management of your wealth through your retirement. Due to sequence risk, early losses can hurt the investor more. Losses at the start of retirement reduce your investment base, making it harder to recover even if markets improve later. Withdrawals lock in these losses. During the accumulation phase, you can ride out market downturns. You’re able to keep your money invested until the market recovers, knowing you have other sources of income. In retirement, you might rely on withdrawals for income. When you make these withdrawals during a downturn, you have to sell more shares to meet expenses, reducing the potential for future growth.

Example of Sequence Risk in Action

The best way to describe sequence risk is to demonstrate it with a hypothetical scenario. Imagine two retirees, both starting retirement with a $1 million portfolio and withdrawing $50,000 annually:

Retiree A experiences a strong market in their early years, with positive returns in the first five years before a downturn later.
Retiree B experiences a market downturn in the first five years but sees strong growth later.

Both investors have the same average return over 10 years, but Retiree B experiences a market downturn in the beginning while Retiree A experiences this later. As a result, retiree B is at a much higher risk of running out of money sooner due to early losses combined with ongoing withdrawals.

To demonstrate this further, imagine both investors experience an average return of 5% over 10 years. The final values of their portfolios may differ greatly based on the impact the state of the market early in their retirement had coupled with their early withdrawals. This is depicted in the tables below:

Retiree A (Strong Early Returns, Weak Later)¹

Year	Return	Portfolio Start	Withdrawal	Portfolio End
1	+15%	$1,000,000	-$50,000	$1,102,500
2	+12%	$1,102,500	-$50,000	$1,169,800
3	+10%	$1,169,800	-$50,000	$1,246,780
4	+8%	$1,246,780	-$50,000	$1,296,522
5	+5%	$1,296,522	-$50,000	$1,311,348
6	-5%	$1,311,348	-$50,000	$1,185,781
7	-8%	$1,185,781	-$50,000	$1,047,722
8	-10%	$1,047,722	-$50,000	$893,950
9	-12%	$893,950	-$50,000	$738,676
10	-15%	$738,676	-$50,000	$573,875

The final value of Retiree A's portfolio after 10 years is $573,875.

Retiree B (Weak Early Returns, Strong Later)²

Year	Return	Portfolio Start	Withdrawal	Portfolio End
1	-15%	$1,000,000	-$50,000	$807,500
2	-12%	$807,500	-$50,000	$664,600
3	-10%	$664,600	-$50,000	$548,140
4	-8%	$548,140	-$50,000	$458,289
5	-5%	$458,289	-$50,000	$388,375
6	+5%	$388,375	-$50,000	$354,794
7	+8%	$354,794	-$50,000	$328,178
8	+10%	$328,178	-$50,000	$320,996
9	+12%	$320,996	-$50,000	$309,515
10	+15%	$309,515	-$50,000	$305,942

The final value of Retiree B's portfolio after 10 years is $305,942.

Retiree B’s final portfolio value was almost half of Retiree A because their portfolio suffered from making withdrawals early in retirement during a market downturn. The difference between the two retirees is that Retiree A began withdrawals during a stronger market these withdrawals made less of a negative overall impact on their portfolio.

How to Protect Against Sequence Risk

Sequence risk is mainly a matter of luck. It all depends on your timing of retirement and the state of the market at that time. The same way it is very difficult for investors to time the market, it is a challenge to time withdrawals. Instead, there are other ways to mitigate sequence risk that allow investors to set up a cushion of protection for their retirement savings. These risk-mitigation strategies include:

Maintain a Cash or Fixed-Income Buffer

Consider keeping one to three years’ worth of expenses in cash or low-volatility investments (like bonds). This could help you avoid selling more volatile stocks during a downturn.

Use a Dynamic Withdrawal Strategy

Instead of withdrawing a fixed amount every year, consider adjusting withdrawals based on market performance. In down years, reducing withdrawals could help preserve the long-term value of your portfolio.

Diversify Your Portfolio

A well-diversified mix of stocks, bonds, and alternative investments can might help cushion losses in any one asset class. In having a diversified portfolio, you can pull from a variety of asset classes, allowing you to stay invested in classes that have an opportunity for growth.

Consider a “Bucket Strategy”

You could consider segmenting your assets into different “buckets”:

Short-term (0-3 years): Cash and bonds for immediate expenses.
Medium-term (3-10 years): A balanced mix of stocks and bonds.
Long-term (10+ years): More aggressive growth investments to outpace inflation.

Find Other Sources of Income

Having other sources of income can allow you to rely less on withdrawals during a market downturn. Whether it is part-time work, freelance work, or another way to experience earnings, you could potentially delay your need for larger withdrawals by having this alternate income. This would allow you to optimize the timing of your withdrawals, staying invested when there is a high opportunity for potential growth.

Final Thoughts

Sequence risk is an important financial risk retirees must consider, and it can often come down to luck on how it impacts you. However, there are strategies that can be used to mitigate the impact this risk can have on your wealth. The key is flexibility—having a plan that allows you to adjust withdrawals and ride out market downturns without depleting your savings too soon. If you’re nearing retirement, now is the time to review your retirement and investment strategies and ensure you're protected against the impact of early market losses.

Would you like to discuss how your portfolio is positioned to handle sequence risk? Our team can help you create a personalized strategy that works to safeguard your retirement. Contact us for further details.

Sources:

Investopedia. "Sequence Risk: Meaning, Retirement, and Protection". (February 4, 2024). Retrieved from https://www.investopedia.com/terms/s/sequence-risk.asp.

Footnotes:

For illustrative purposes only. Not based on historic data.
For illustrative purposes only. Not based on historic data.

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