Sequence of Returns Risk: Why the First 5 Years of Retirement Determine Everything
Sequence of Returns Risk: Why the First 5 Years of Retirement Determine Everything
COACHING POINTS
- The Trap: In the accumulation phase, a market crash is a gift (you buy cheaper). In the withdrawal phase, a market crash is a disaster. Selling assets while they are down permanently depletes the portfolio, making recovery impossible even if the market rebounds later.
- The Math: Two retirees can have the exact same “Average Annual Return” (e.g., 8%) over 30 years. But if Retiree A faces negative returns in the first 5 years, they go broke. Retiree B, who sees growth early, dies wealthy. The order of returns matters more than the average.
- The Defense: You must insulate your spending needs from the stock market during the “Retirement Red Zone” (5 years before/after retirement) using a Bond Tent or Cash Buffer.
The greatest danger to your retirement is not running out of money at age 90; it’s the market crashing at age 65. This phenomenon, known as Sequence of Returns Risk (SORR), creates a mathematical “death spiral.” When you withdraw cash from a shrinking portfolio, you are forced to sell more shares to generate the same income, accelerating the depletion of your nest egg. Source: Wade Pfau / Trinity Study Updates
Scenario: You have $1,000,000. You withdraw $50,000/year (5%).
- Scenario A (Bull Market Start):
Year 1 Market: +20%. Portfolio grows to $1.2M.
Withdrawal: $50k is easily covered by gains. Principal remains intact. - Scenario B (Bear Market Start):
Year 1 Market: -20%. Portfolio drops to $800,000.
Withdrawal: You take $50k. Portfolio is now $750,000.
The Impact: You now need a 33% gain just to get back to where you started. The withdrawal acts as “Reverse Dollar Cost Averaging,” selling more shares when prices are low.
What-If Scenario: Same Average, Different Order
Comparison: Two portfolios with 8% average return over 20 years.
| Sequence Type | Start of Retirement | Ending Balance ($) |
|---|---|---|
| Lucky Sequence | Bull Market (+20%, +10%…) | $2,500,000 (Wealth Abundance) |
| Unlucky Sequence | Bear Market (-20%, -10%…) | $0 (Bankruptcy by Year 15) |
Portfolio Depletion Speed
| Market Scenario (First 3 Years) | Portfolio Life Expectancy (Years) |
|---|---|
| Steady Growth (+7% avg) | 30 |
| Early Crash (-15% avg) | 12 |
*An early market crash cuts the lifespan of a portfolio by more than half if withdrawals are not adjusted.
Safe Withdrawal Rate (SWR) Reality
| Market Condition | Sustainable SWR (%) |
|---|---|
| Normal Market | 4.5 |
| Worst Case (1966 Cohort) | 3.8 |
*The famous “4% Rule” is based on the worst-case historical sequence (1966). In most normal periods, you could safely withdraw more, but you must plan for the worst.
Execution Protocol
Leading up to retirement, shift assets from Stocks to Bonds/Cash to hit your maximum defensive allocation (e.g., 60/40) on Day 1 of retirement. Then, slowly shift back into stocks over the next 10 years (Rising Equity Glide Path).
Keep 2-3 years of living expenses in Cash or T-Bills. If the market crashes, stop selling stocks. Spend the cash bucket instead. This buys time for your stocks to recover without being sold at a loss.
If the portfolio drops by 20%, cut your discretionary spending (travel, dining) by 20%. Variable withdrawal strategies (like Guyton-Klinger) are mathematically superior to fixed inflation-adjusted withdrawals.
COACHING DIRECTIVE
- Do This: Assess your SORR exposure 5 years before retiring. If a 30% drop would wreck your plan, you are too aggressive. De-risk immediately.
- Avoid This: retiring with 100% stocks and no cash buffer. You are gambling your entire financial future on the first 36 months of market performance.
Frequently Asked Questions
Does working longer help?
Yes. Working just “One More Year” creates a double benefit: it shortens the withdrawal period and adds another year of savings, drastically reducing Sequence of Returns Risk.
Are dividends immune?
Partially. If you live only on dividends and interest without selling shares, you are immune to SORR because you never realize the capital loss. However, few retirees have a portfolio large enough to live solely on yield.
What is the Red Zone?
The “Retirement Red Zone” is usually defined as the 5 years before and the 5 years after retirement. This 10-year window is where SORR strikes hardest.