Sequence of Returns Risk: Why Early Retirement Years Matter Most

You've spent decades building your retirement savings. You've watched your 401(k) grow through ups and downs, trusting that the market's long-term average returns will carry you through retirement. But there's a catch that can derail even the most carefully planned retirement: when those returns happen matters just as much as what they average.

This is sequence of returns risk, and it's the reason why experiencing a market crash in your first few years of retirement can be far more devastating than the same crash happening 20 years into retirement. Understanding this concept isn't just academic. It's the difference between a retirement that lasts and one that runs dry.

Sequence of returns risk is the danger that poor investment returns early in retirement, combined with ongoing withdrawals, will deplete your portfolio faster than if the same poor returns happened later. The technical term sounds complicated, but the concept is straightforward once you see it in action.

During your working years, when you're contributing to your 401(k) or IRA, sequence of returns doesn't matter much. In fact, market crashes can work in your favor because you're buying investments at lower prices. But the moment you retire and start withdrawing money, everything changes. Now you're selling investments to fund your lifestyle, and if you're forced to sell during a downturn, you lock in those losses permanently.

Here's the critical insight: when you withdraw money during a market decline, you remove shares from your portfolio that will never participate in the eventual recovery. This creates a mathematical disadvantage that compounds over time.

Let's look at a real-world example that makes this crystal clear. Meet Sarah and Tom, both retiring at 65 with exactly $1 million in their portfolios. Both plan to withdraw $50,000 per year (a 5% initial withdrawal rate, adjusted for inflation). Both experience the exact same market returns over 30 years, averaging 7% annually. The only difference? The order in which those returns occur.

Sarah's scenario (good returns early):

• Years 1-5: Average 12% annual returns
• Years 6-25: Average 7% annual returns
• Years 26-30: Average -2% annual returns
• Result: Portfolio lasts through retirement with money remaining

Tom's scenario (poor returns early):

• Years 1-5: Average -2% annual returns
• Years 6-25: Average 7% annual returns
• Years 26-30: Average 12% annual returns
• Result: Portfolio depleted by year 23, leaving 7 years unfunded

Both experienced a 7% average annual return. Both withdrew the same inflation-adjusted amounts. Yet Tom runs out of money while Sarah doesn't. This is sequence of returns risk in action, and it's why financial advisors lose sleep over early retirement market crashes.

The first 5-10 years of retirement are often called the "fragile decade" for good reason. This period determines whether your retirement plan succeeds or fails, regardless of what happens afterward. Here's why those early years are so critical:

You have the most money at risk. Your portfolio is at its peak value right when you retire. A 20% market decline on $1 million costs you $200,000. The same percentage decline 20 years later, when your portfolio might be worth $400,000 after withdrawals, only costs $80,000.

You're making the largest withdrawals. In dollar terms, your early withdrawals are your biggest even if the percentage stays the same. That $50,000 first-year withdrawal is 5% of $1 million, but if your portfolio drops to $800,000 after losses and withdrawals, you're now taking 6.25% the next year to maintain your lifestyle.

There's less time to recover. When you're 66 and the market crashes, you have fewer years for compound growth to work its magic compared to when you were 46. Those missing shares you sold during the downturn never get replaced, and you never recapture their potential growth.

Understanding sequence of returns risk isn't about predicting market crashes or timing your retirement perfectly. It's about building defenses into your retirement plan. Consider these real scenarios Americans have faced:

The 2000-2002 tech crash retiree: Someone who retired in January 2000 with a stock-heavy portfolio watched the market decline over 40% by October 2002. If they stuck to their planned withdrawals, they permanently removed shares at rock-bottom prices. Many were forced to reduce their standard of living or return to work.

The 2008 financial crisis retiree: Retiring in 2008 meant facing a 50%+ stock market decline within your first year. Even though the market recovered by 2013, portfolios that sustained withdrawals during the crash often never fully recovered because so many shares were sold at depressed prices.

The fortunate 2010 retiree: Someone retiring in 2010 enjoyed over a decade of mostly positive returns before facing the 2020 COVID crash. By then, their portfolio had grown substantially, they'd already taken years of withdrawals, and they had less total money at risk.

The difference in outcomes for these three groups is stark, despite similar long-term market performance. This is why financial advisors recommend being most conservative right around your retirement date.

The good news? You can't control when markets crash, but you can control how exposed you are. Here are practical strategies financial planners recommend:

Build a cash reserve buffer. Many advisors suggest keeping 1-2 years of expenses in cash or short-term bonds. During market downturns, you draw from this reserve instead of selling stocks at depressed prices. This gives your equity portfolio time to recover without forced selling. With the 2024 contribution limits, your last few years of 401(k) contributions ($23,000 annually, or $30,500 if you're 50+) can help build this cushion.

Use a "bucket" strategy. Divide your portfolio into three buckets: immediate needs (1-2 years in cash), medium-term (3-10 years in bonds), and long-term growth (10+ years in stocks). You only tap the stock bucket when markets are favorable, protecting against sequence risk while maintaining growth potential.

Consider a variable withdrawal strategy. Instead of withdrawing a fixed inflation-adjusted amount every year, adjust your spending based on portfolio performance. In down years, tighten the belt by 5-10%. In strong years, give yourself a raise. This flexibility can dramatically extend portfolio longevity.

Delay Social Security. Each year you delay claiming between 62 and 70 increases your monthly benefit by roughly 8% (after adjusting for inflation). Delaying creates a form of longevity insurance and reduces how much you need to withdraw from your portfolio during those critical early years. Full retirement age for most current retirees is 66-67, but waiting until 70 maximizes benefits.

Shift your asset allocation gradually. Many people move from a growth-focused allocation (like 80% stocks) to a more conservative one (perhaps 50-60% stocks) in the years just before and after retirement. This "glide path" approach reduces exposure to market volatility during the fragile decade. You can then gradually increase stock exposure again if markets cooperate.

Generate guaranteed income streams. Consider allocating a portion of assets to immediate annuities, which convert a lump sum into guaranteed lifetime income. While controversial and not right for everyone, they can cover essential expenses and reduce the amount you need to withdraw from your portfolio during market downturns. Just be sure you understand the fees and terms.

Misconception 1: "Average returns are what matter." During accumulation, averages work reasonably well for planning. During distribution (retirement), the sequence of returns completely changes the math. Two portfolios with identical average returns can produce vastly different outcomes based solely on the order of those returns.

Misconception 2: "I just won't sell during downturns." Unless you have other income sources covering all your expenses, you'll need to withdraw money for living costs regardless of market conditions. That's what makes retirement different from the accumulation phase. The bills don't stop coming during bear markets.

Misconception 3: "This only matters if you retire at the wrong time." While retiring right before a crash is worst-case, sequence risk affects everyone who withdraws from investments. Even retirees who experience early gains should remain aware, because a severe late-retirement crash combined with Required Minimum Distributions (starting at age 73) can create similar problems.

Misconception 4: "The 4% rule accounts for this." The famous 4% withdrawal rule (withdrawing 4% of your initial portfolio value, adjusted for inflation) was specifically designed to survive sequence risk based on historical data. However, it's not foolproof, and with today's lower bond yields and higher valuations, many advisors suggest starting at 3-3.5% for added safety.

Understanding sequence of returns risk should influence several key retirement decisions:

Retirement timing: If you're approaching retirement during a strong bull market, you might consider retiring on schedule or even slightly early. If we're in the midst of a bear market, working an extra year or two can make a significant difference in outcomes. Each additional year means one less year of portfolio withdrawals and more time for recovery.

Withdrawal strategy: Be prepared to adjust your spending, especially in the first decade. Having discretionary expenses you can cut during down years provides flexibility. Your essential spending (housing, healthcare, food) might come from Social Security and pensions, while discretionary spending (travel, gifts, entertainment) comes from portfolio withdrawals you can reduce if needed.

Asset location: Keep tax-advantaged accounts like your 401(k) and traditional IRA invested for growth, while maintaining your cash buffer in regular taxable accounts. This allows flexibility in what you withdraw and when. Roth IRAs can serve as emergency reserves since you can withdraw contributions tax-free anytime.

Healthcare planning: Until you're eligible for Medicare at 65, healthcare costs can be substantial. Factor these into your early retirement budget. Health Savings Accounts (HSAs) offer triple tax advantages and can serve as both healthcare reserves and retirement savings if you're eligible.

Disclaimer: This article is for informational purposes only and should not be considered financial advice. fidser. is not a certified financial planning service. Every individual's financial situation is unique, and you should consult with a qualified financial advisor, certified financial planner (CFP), or other financial professional before making any investment or retirement decisions. Past market performance does not guarantee future results.