Sequence of Returns Risk: Why Early Bad Markets Hurt Retirees

The question I hear most from people about to retire is not whether the market will have a bad year. Everyone knows it will. The real worry sounds more like this: what if the bad year comes right after I stop working, when I am living off my savings and there is no paycheck to fall back on?

I am Bradley Stone, an independent agent here in Central Florida, and that worry is well founded. It even has a name, sequence of returns risk. It is one of the most important ideas in retirement income and one of the least explained. In this article I will walk through what it means, show a simple hypothetical example with the arithmetic laid out, and cover the general ways people make their plans less sensitive to it.

What sequence of returns risk means

While you are saving and not taking money out, the order of good and bad years does not change where you end up. A loss of 20 percent followed by a gain of 10 percent leaves you in the same place as a gain of 10 percent followed by a loss of 20 percent. The math simply multiplies the same numbers in a different order.

Everything changes once you start taking money out. When you withdraw during a down year, you are selling at a low point to pay your bills. The money you sold is gone, and it is not there to recover when the market comes back. A later good year only grows what is left.

So sequence of returns risk is the danger that bad years arrive early in retirement, while you are making withdrawals, and permanently shrink the savings you are counting on for the next twenty or thirty years. Two people can earn exactly the same average return and still end up in very different places, purely because of the order.

A hypothetical example: same average, different order

This example is hypothetical and for illustration only. The returns are made up round numbers, not real market history, and they are not a prediction of what any investment will do. It also ignores fees, taxes, and inflation to keep the arithmetic easy to follow.

Meet two hypothetical retirees, Linda and Frank. Each starts retirement with $500,000. Each takes out $30,000 at the start of every year to live on. Over ten years, each of them experiences exactly the same ten annual returns: one year with a loss of 20 percent, one year with a loss of 10 percent, and eight years with a gain of 10 percent. Add those up and divide by ten, and both have an average return of 5 percent a year.

The only difference is the order.

Linda gets the bad years first

Linda retires into the two losing years.

In year one she takes out $30,000, leaving $470,000. The market falls 20 percent, and she ends the year with $376,000.

In year two she takes out another $30,000, leaving $346,000. The market falls 10 percent, and she ends the year with about $311,000.

Then eight good years in a row arrive, each with a 10 percent gain. Here is the painful part. With only about $281,000 left after her third withdrawal, a 10 percent gain earns her about $28,000, which is less than the $30,000 she takes out each year. So even in good years her balance keeps slowly sliding. After ten years, Linda has about $290,000 left.

Frank gets the bad years last

Frank has the exact same returns in reverse order. His eight good years come first, then the loss of 10 percent, then the loss of 20 percent.

In year one he takes out $30,000, leaving $470,000, which grows 10 percent to $517,000. Because his balance stays well above $300,000, each 10 percent gain earns him more than the $30,000 he withdraws. By the end of year eight, he has about $694,000.

Then the bad years hit. In year nine he takes out $30,000 and the market falls 10 percent, leaving about $598,000. In year ten he takes out $30,000 and the market falls 20 percent, leaving about $454,000.

What the example shows

Both retirees withdrew the same $300,000 over the ten years. Both had the same 5 percent average return. Linda ended with about $290,000. Frank ended with about $454,000. That is a difference of roughly $164,000, and it came entirely from when the bad years showed up.

Here is the proof that the withdrawals are what cause it. If neither of them had taken any money out, both would have ended the ten years with about $772,000, exactly the same amount, because without withdrawals the order does not matter.

And notice where each of them stands going forward. Linda still needs $30,000 a year and has about $290,000 to draw from. Frank needs the same amount and has about $454,000. Their next decade looks very different.

Why the first years of retirement matter most

The early years carry the most weight for a few simple reasons.

Your balance is usually at its largest right when you retire, so a percentage loss is the largest loss in dollars you will ever take. Your withdrawals then become a bigger slice of a smaller pile, which is exactly what happened to Linda. And you have the most years still ahead of you that depend on that money.

A loss late in retirement still hurts, but by then you have already been living on your savings for many years, and fewer future years depend on what is left. That is why many people pay special attention to the handful of years just before and just after they stop working.

What makes the risk bigger or smaller

A few things change how exposed any one person is.

• How large your withdrawals are compared with your savings. The bigger the share you take out each year, the more a bad early stretch can hurt.
• Whether your withdrawals can bend. If you can spend less in a bad year, you sell less at low prices.
• How much of your essential spending is already covered by income that does not depend on the market, such as Social Security or a pension.
• How much of the money you are drawing from can fall in value. That is a question about how your investments are set up, and it belongs with whoever helps you manage them.

General ways people reduce it

None of these are recommendations for your situation. They are the common approaches worth understanding, each with its own tradeoffs.

A cash reserve for spending

Some people set aside money for near term spending in cash or similar accounts that do not swing with the market. When the market drops, they spend from the reserve instead of selling investments at a low point, and give the rest time to recover. The tradeoff is that cash usually earns less and loses ground to inflation, and a reserve only helps if the downturn is shorter than the reserve lasts. How much to hold is a personal question.

Flexible withdrawals

Spending less in bad years can make a real difference. Going back to our hypothetical Linda, suppose she had taken $20,000 instead of $30,000 in each of her two losing years, then gone back to $30,000. She would have spent $20,000 less in total, but she would have ended the ten years with about $325,000 instead of about $290,000. That is about $35,000 more, from $20,000 of belt tightening. The tradeoff is that this only works for spending that can actually be cut. Your electric bill and your insurance premiums do not care what the market did.

Guaranteed income for essential expenses

The less you need to pull from your investments in a bad year, the less the order of returns matters. That is why many people try to cover their essential bills with dependable income. Social Security is the base for most people, and your monthly benefit grows for each month you wait past your full retirement age, up to age 70, which is covered in my article on when to take Social Security. Members of the Florida Retirement System Pension Plan have a lifetime monthly benefit that does the same job. For some people, an annuity can add to that floor. Any guarantee from an annuity is backed by the claims paying ability of the insurance company that issues it. My article on whether to use an annuity or stay invested walks through the tradeoffs in detail.

When an annuity is the wrong answer to this risk

Because I work with annuities, I want to be especially clear here. An annuity is not the automatic answer to sequence of returns risk, and sometimes it is the wrong one.

• If Social Security and a pension already cover your essential bills, you may already have the floor you need.
• If you might need the money in the next several years, surrender charges make an annuity a poor place for it.
• If your spending is flexible and you are comfortable riding out down years, a cash reserve or flexible withdrawals may do the job without locking up any money.
• If your health suggests a shorter retirement, lifetime income is worth less to you.
• If lower growth potential would leave you short of your goals, giving up upside to reduce this one risk may not be a good trade.
• If anyone tells you an annuity is the only way to handle this risk, that is a sales pitch, not an explanation.

Questions worth asking before deciding

• Which of my monthly bills are essential, and what income covers them today?
• If the market fell sharply in my first year of retirement, what would I cut, and what could I not cut?
• How many months of spending could I cover without selling anything that has dropped in value?
• Has anyone shown me what my plan looks like if the bad years come first instead of last?
• If I wait to claim Social Security, how will I cover the years in between?
• If an annuity is suggested, how much flexibility am I giving up, and for how long?

Where I can help

My part of this is the guaranteed income side. As an independent agent, I help people figure out whether there is a gap between their essential bills and their Social Security and pension income, and if there is, whether an annuity is a sensible way to fill part of it. When it is, I compare contracts from a wide range of top rated carriers. You can learn more about the annuities I help with, read my plain overview of how annuities turn savings into income, or see how much monthly income your savings might produce.

I do not manage investments, and I do not tell anyone how to invest what stays in the market. If you work with someone on that side, I am glad to work alongside them so your income plan and your investments fit together.

Let us look at your first few years

If you live in Orlando, Clermont, Winter Garden, Apopka, Altamonte Springs, Lakeland, or anywhere nearby and you are nearing retirement, the years right around your retirement date deserve a careful look. I would be glad to sit down and talk through your essential bills, your other income, and whether a bad early stretch would put your plan at risk. There is no pressure and no obligation. Call 407.878.8277 or request a free quote.

This article is general education, not tax, legal, or investment advice. Your own situation deserves a personal review.