Understanding Sequence of Return Risk: The Hidden Threat to Retirement and Early Retirement
Sequence of return risk (SORR) is a critical yet often overlooked concept in retirement and early retirement planning. It highlights how the order of investment returns can significantly impact the longevity of a portfolio, especially when regular withdrawals are involved. While the average return over a period might look appealing, the sequence in which those returns occur can spell success or disaster for retirees.
To illustrate the impact of SORR, this article includes a case study comparing two hypothetical investors who start with identical portfolios but experience returns in different sequences. The difference in outcomes is startling.
What Is Sequence of Return Risk?
Sequence of return risk refers to the risk of receiving poor investment returns early in retirement when withdrawals are being made from a portfolio. During this phase, negative returns can compound the depletion of funds, making it difficult for the portfolio to recover.
Key Drivers of SORR:
Portfolio Withdrawals: Regular withdrawals during a bear market can lock in losses, shrinking the base on which future growth occurs.
Timing of Returns: Early negative returns are far more damaging than late negative returns, as the portfolio is largest during the initial years of retirement.
Longevity of Retirement: For early retirees, SORR is amplified because the portfolio must sustain withdrawals over several decades.
Case Study: Two Investors with $1M Starting Balances
Scenario Details:
Portfolio Start Balance: $1,000,000
Annual Withdrawal: $40,000 (adjusted for inflation using the CPI Index)
Investment Returns: Using S&P 500 returns from 2000 to 2020 for the first investor and the same returns in reverse for the second investor.
Historical S&P 500 Returns (2000–2020):
The period from 2000 to 2002 saw significant losses (-9.1%, -11.9%, -22.1%).
The subsequent years had a mix of strong positive and negative returns, including the 2008 financial crisis (-36.55%) and the strong recovery thereafter (2009: +25.94%, 2019: +28.88%).
Investor 1: Experiences returns in chronological order (2000 to 2020). Investor 2: Experiences the same returns in reverse order (2020 to 2000).
Let’s analyze how their portfolios perform over 20 years.
Results of the Case Study
Below is the detailed table for Scenario A (all figures in $, rounded).
Year | Start of Year Balance | S&P 500 Return % | Balance Before Withdrawal | Withdrawal ($) | End of Year Balance | Next Year’s Withdrawal (Inflation-Adjusted) |
2000 | 1,000,000 | -9.10% | 909,000 | 40,000 | 869,000 | 40,000 × 1.0336 = 41,344 |
2001 | 869,000 | -11.89% | 765,876 | 41,344 | 724,532 | 41,344 × 1.0283 = 42,516 |
2002 | 724,532 | -22.10% | 565,333 | 42,516 | 522,817 | 42,516 × 1.0159 = 43,194 |
2003 | 522,817 | +28.68% | 673,043 | 43,194 | 629,849 | 43,194 × 1.0227 = 44,179 |
2004 | 629,849 | +10.88% | 698,715 | 44,179 | 654,536 | 44,179 × 1.0268 = 45,364 |
2005 | 654,536 | +4.91% | 686,748 | 45,364 | 641,384 | 45,364 × 1.0339 = 46,899 |
2006 | 641,384 | +15.79% | 742,942 | 46,899 | 696,043 | 46,899 × 1.0324 = 48,421 |
2007 | 696,043 | +5.49% | 734,280 | 48,421 | 685,859 | 48,421 × 1.0285 = 49,803 |
2008 | 685,859 | -37.00% | 432,090 | 49,803 | 382,287 | 49,803 × 1.0384 = 51,722 |
2009 | 382,287 | +26.46% | 483,264 | 51,722 | 431,542 | 51,722 × 0.9966 = 51,545 (-0.34%) |
2010 | 431,542 | +15.06% | 496,556 | 51,545 | 445,011 | 51,545 × 1.0164 = 52,396 |
2011 | 445,011 | +2.11% | 454,387 | 52,396 | 402,000 | 52,396 × 1.0316 = 54,050 |
2012 | 402,000 | +16.00% | 466,320 | 54,050 | 412,270 | 54,050 × 1.0207 = 55,169 |
2013 | 412,270 | +32.39% | 546,140 | 55,169 | 490,971 | 55,169 × 1.0146 = 55,972 |
2014 | 490,971 | +13.69% | 558,473 | 55,972 | 502,501 | 55,972 × 1.0162 = 56,881 |
2015 | 502,501 | +1.38% | 509,986 | 56,881 | 453,105 | 56,881 × 1.0012 = 56,949 |
2016 | 453,105 | +11.96% | 507,398 | 56,949 | 450,449 | 56,949 × 1.0126 = 57,665 |
2017 | 450,449 | +21.83% | 548,859 | 57,665 | 491,194 | 57,665 × 1.0213 = 58,895 |
2018 | 491,194 | -4.38% | 470,679 | 58,895 | 411,784 | 58,895 × 1.0244 = 60,333 |
2019 | 411,784 | +31.49% | 541,789 | 60,333 | 481,456 | 60,333 × 1.0181 = 61,421 |
2020 | 481,456 | +18.40% | 569,854 | 61,421 | 508,433 | — |
Ending Balance (Scenario A, end of 2020):$508,433 (approx.)
Year | Start Balance | Return % | Balance Before WD | Withdrawal ($) | End of Year Balance | Next Year’s Withdrawal (Inflation-Adjusted) |
2000 | 1,000,000 | +18.40% | 1,184,000 | 40,000 | 1,144,000 | $40,000 → 40,000×1.0336 = 41,344 |
2001 | 1,144,000 | +31.49% | 1,504,706 | 41,344 | 1,463,362 | 41,344×1.0283 = 42,519 |
2002 | 1,463,362 | -4.38% | 1,399,642 | 42,519 | 1,357,123 | 42,519×1.0159 = 43,195 |
2003 | 1,357,123 | +21.83% | 1,652,399 | 43,195 | 1,609,204 | 43,195×1.0227 = 44,180 |
2004 | 1,609,204 | +11.96% | 1,801,851 | 44,180 | 1,757,671 | 44,180×1.0268 = 45,369 |
2005 | 1,757,671 | +1.38% | 1,781,187 | 45,369 | 1,735,818 | 45,369×1.0339 = 46,899 |
2006 | 1,735,818 | +13.69% | 1,972,127 | 46,899 | 1,925,228 | 46,899×1.0324 = 48,421 |
2007 | 1,925,228 | +32.39% | 2,549,776 | 48,421 | 2,501,355 | 48,421×1.0285 = 49,803 |
2008 | 2,501,355 | +16.00% | 2,901,573 | 49,803 | 2,851,770 | 49,803×1.0384 = 51,722 |
2009 | 2,851,770 | +2.11% | 2,912,653 | 51,722 | 2,860,931 | 51,722×(1 – 0.0034) = 51,545 |
2010 | 2,860,931 | +15.06% | 3,292,339 | 51,545 | 3,240,794 | 51,545×1.0164 = 52,396 |
2011 | 3,240,794 | +26.46% | 4,100,456 | 52,396 | 4,048,060 | 52,396×1.0316 = 54,050 |
2012 | 4,048,060 | -37.00% | 2,550,279 | 54,050 | 2,496,229 | 54,050×1.0207 = 55,162 |
2013 | 2,496,229 | +5.49% | 2,632,426 | 55,162 | 2,577,264 | 55,162×1.0146 = 55,966 |
2014 | 2,577,264 | +15.79% | 2,986,139 | 55,966 | 2,930,173 | 55,966×1.0162 = 56,875 |
2015 | 2,930,173 | +4.91% | 3,073,188 | 56,875 | 3,016,313 | 56,875×1.0012 = 56,943 |
2016 | 3,016,313 | +10.88% | 3,342,180 | 56,943 | 3,285,237 | 56,943×1.0126 = 57,662 |
2017 | 3,285,237 | +28.68% | 4,231,871 | 57,662 | 4,174,209 | 57,662×1.0213 = 58,888 |
2018 | 4,174,209 | -22.10% | 3,253,180 | 58,888 | 3,194,292 | 58,888×1.0244 = 60,330 |
2019 | 3,194,292 | -11.89% | 2,814,617 | 60,330 | 2,754,287 | 60,330×1.0181 = 61,417 |
2020 | 2,754,287 | -9.10% | 2,504,585 | 61,417 | 2,443,168 | — |
Ending Balance (Scenario B, end of 2020):$2,443,168 (approx.)
Key Observations:
Investor 1:
Suffers early losses from the 2000-2002 downturn and the 2008 financial crisis.
Despite a strong recovery from 2009 onwards, the portfolio balance ends at $508,433 after 20 years, reflecting significant depletion due to withdrawals and poor early returns.
Investor 2:
Benefits from early strong returns, which allow the portfolio to grow even with withdrawals.
Despite the later downturns (2000-2002 losses), the portfolio ends at a robust $2,443,168 after 20 years, showcasing how later losses are far less impactful when the portfolio is already substantial.
Key Takeaways from the Case Study
Timing Trumps Average Returns: Both investors experienced the same average annual return, yet their outcomes were drastically different due to the sequence of those returns.
Early Losses Are Devastating: Investor 1 depleted their portfolio rapidly due to early negative returns combined with withdrawals.
Later Losses Are Manageable: Investor 2 preserved their portfolio because early gains provided a cushion against later losses.
Managing Sequence of Return Risk
To mitigate SORR, retirees and early retirees should consider these strategies:
1. Build a Cash Reserve
Maintain 2–3 years' worth of living expenses in cash equivalents and short-duration bonds to avoid selling investments during market downturns.
2. Adopt a Dynamic Withdrawal Strategy
Reduce withdrawals during years of poor market performance and increase them during strong market years. Tools like the guardrail strategy can help balance withdrawals with portfolio health.
3. Diversify Investments
Include a mix of asset classes—such as stocks, bonds, and alternative investments—to reduce overall portfolio volatility.
4. Use Bucketing
Divide your portfolio into "buckets" for short-term, medium-term, and long-term needs. This ensures that near-term withdrawals are not exposed to stock market fluctuations.
5. Delay Social Security (if applicable)
For traditional retirees, delaying Social Security benefits can provide a higher guaranteed income later, reducing reliance on portfolio withdrawals during bear markets.
Conclusion: Plan Ahead for Sequence of Return Risk
Sequence of return risk is a silent threat that can derail retirement plans, particularly for those pursuing early retirement. As this case study demonstrates, the timing of returns matters just as much—if not more—than the returns themselves.
By understanding SORR and implementing strategies to mitigate its effects, retirees can better secure their financial future. Whether through building cash reserves, diversifying investments, or adopting flexible withdrawal strategies, proactive planning is essential.
For those navigating these complexities, working with a Certified Financial Planner (CFP) and tax expert ensures a tailored strategy that accounts for market risks, tax efficiency, and long-term financial goals. Sequence of return risk is not something to fear—it’s something to plan for.