Average returns don't tell the whole story. Two portfolios with identical average returns can produce dramatically different outcomes depending on the ORDER of those returns. This is sequence-of-returns risk—and it can make or break your retirement.
The Sequence Problem
During Accumulation: Sequence Doesn't Matter Much
While you're adding money, bad early years mean you're buying cheap. You have time to recover.
During Withdrawal: Sequence Is Everything
When you're withdrawing money, bad early years are devastating. You're selling at lows AND depleting principal faster.
The math: Withdrawals + losses = permanent portfolio reduction with no chance to recover.
A Numerical Example
Two Identical Average Returns, Different Sequences
Portfolio A: Good returns early, bad later Portfolio B: Bad returns early, good later
Both average 5% annually over 20 years.
Assumptions:
- Starting: $1,000,000
- Annual withdrawal: $50,000 (5%)
Portfolio A sequence (good first): Year 1: +20%, Year 2: +15%, Year 3: +10%... then declining
Portfolio B sequence (bad first): Year 1: -20%, Year 2: -15%, Year 3: -10%... then improving
After 20 years (same average return):
- Portfolio A: ~$750,000 remaining
- Portfolio B: ~$200,000 remaining (or depleted!)
Same average returns. Dramatically different outcomes.
Why Early Losses Are Devastating
The Withdrawal Effect
Without withdrawals:
- $1M loses 20% → $800,000
- Needs 25% gain to recover → $1,000,000
With $50,000 withdrawal:
- $1M loses 20% → $800,000
- Withdraw $50,000 → $750,000
- Needs 33% gain to recover → $1,000,000
Early losses combined with withdrawals create a hole that's harder to escape.
The Retirement Risk Zone
The 5 years before and 10 years after retirement are the "danger zone." Poor returns during this window do the most damage.
Mitigating Sequence Risk
1. The Bond Tent Strategy
Increase bond allocation approaching and just after retirement, then gradually reduce.
Example:
- Age 50: 60% stocks / 40% bonds
- Age 65 (retirement): 40% stocks / 60% bonds
- Age 75: 50% stocks / 50% bonds
- Age 85: 60% stocks / 40% bonds
Higher bond allocation during the risk zone cushions early retirement returns.
2. Cash/Bond Bucket
Keep 2-5 years of expenses in cash and short-term bonds.
How it works:
- Good market: Withdraw from portfolio, replenish bucket
- Bad market: Live on bucket, let portfolio recover
- Don't sell stocks when they're down
The math: 3 years of expenses at $60,000/year = $180,000 bucket
This buys time—most bear markets recover within 3 years.
3. Flexible Withdrawal Rates
Reduce spending in bad years. Guard rails approach:
- Good years: Increase withdrawal by inflation + something
- Bad years: Cut withdrawal by 5-10%
Example guard rails:
- If portfolio drops 20%: Cut spending 10%
- If portfolio rises 25%: Increase spending 10%
Flexibility extends portfolio longevity dramatically.
4. The Rising Equity Glidepath
Counter-intuitive: Start retirement with lower stock allocation, INCREASE over time.
Rationale:
- If early returns are bad, you didn't have much stock exposure
- If early returns are good, you have more to invest in stocks later
- Protects against the most damaging scenario
5. Delaying Social Security
Every year you delay Social Security (up to 70) increases benefits by 8%.
- Start at 62: Reduced benefits for life
- Start at 70: 76% higher than at 62
Delaying creates a larger guaranteed income floor, reducing portfolio withdrawal needs during the risk zone.
The 4% Rule and Sequence Risk
What the 4% Rule Says
Withdraw 4% initially, adjust for inflation. Historically survives most 30-year periods.
What It Doesn't Account For
- Sequence risk in worst-case scenarios
- Lower future expected returns
- Individual circumstances
Better Framing
4% is a starting point, not a guarantee. Be prepared to adjust.
Dynamic Withdrawal Strategies
The Guyton-Klinger Guard Rails
Reduce withdrawals if portfolio drops; increase if it rises. Specific decision rules.
VPW (Variable Percentage Withdrawal)
Withdrawal rate adjusts annually based on portfolio value and remaining time horizon. Built-in math prevents premature depletion.
CAPE-Based Withdrawal
Adjust withdrawal rate based on market valuation (Shiller CAPE ratio). Lower rate when market is expensive.
Liability-Matching
Match guaranteed income (Social Security, pensions, annuities) to essential expenses. Variable income from portfolio for discretionary spending.
Annuities as Sequence Insurance
The Role of Annuities
Annuities provide guaranteed income regardless of market performance. Transfer sequence risk to the insurance company.
When Annuities Make Sense
- Cover essential expenses not met by Social Security/pension
- Extremely conservative investors
- Health suggests long life
- Desire for simplicity
Types for Sequence Protection
- SPIA (Single Premium Immediate Annuity): Immediate guaranteed income
- DIA (Deferred Income Annuity): Purchase now, income starts later
- QLAC: Purchase in IRA, income at 80+, reduces RMDs
The Trade-Off
You give up liquidity and growth potential for certainty. Some consider this expensive insurance; others value the peace of mind.
Testing Your Plan: Monte Carlo Simulation
What It Does
Runs thousands of simulated market scenarios to estimate probability of success.
Example output: "Your plan succeeds in 85% of historical scenarios."
Limitations
- Based on historical data that may not repeat
- Doesn't account for behavioral responses
- Success ≠ certainty
How to Use It
- Target 80-90% success probability
- If lower, adjust plan (save more, spend less, retire later)
- Rerun periodically as circumstances change
The Bottom Line
Sequence-of-returns risk is the biggest threat to early retirees. Average returns mean nothing if bad years come first. Mitigate with bond tents, cash buckets, flexible spending, delayed Social Security, and possibly annuities. Test your plan with Monte Carlo simulations and build in flexibility.