Sequence of Returns Risk: What It Is, a Real Example, and How to Manage It

What is sequence of returns risk?

Sequence of returns risk is the danger that bad market years arrive early in retirement, while withdrawals are running. Two retirees can earn the exact same returns and end up with very different money, because the order changed.

It's a withdrawal problem. With no money coming out, order doesn't matter at all. Once a client is spending, a loss in year two does far more damage than one in year eighteen.

How does sequence of returns risk work?

Every withdrawal sells shares. Sell them after a crash and you have to sell more shares to raise the same dollars. Those shares are gone before the recovery shows up.

1. The market falls. The portfolio shrinks.
2. The withdrawal stays the same. The client still needs the same income, so it becomes a bigger slice of a smaller pot.
3. The recovery works on less capital. A strong rebound on a depleted balance doesn't replace what was sold at the bottom.

Here's the math that hurts. A 30% loss needs a 43% gain to get back to even. Take a 5% withdrawal on top of that loss and the required gain climbs past 50%.

Sequence of returns risk example: 2000 to 2019, forward and backward

This example uses real S&P 500 total returns for the calendar years 2000 through 2019. They averaged about 7.7% a year. The compound rate was about 6.1%.

Start with $1 million, fully in the index. Take no withdrawals. Run the years in their real order and you end with about $3.25 million. Run the same years in reverse, 2019 first. You end with the same $3.25 million. Order is irrelevant.

Now take $50,000 at the start of each year. Same returns, same starting balance.

• Real order, starting in 2000. The client meets 2000, 2001 and 2002 first, at -9.1%, -11.9% and -22.1%. The balance is about $519,000 after three years. Then 2008 takes it to about $353,000. It ends 2019 near $273,000.
• Reverse order, starting with 2019. The client meets 31.5%, -4.4% and 21.8% first. The balance is about $1.34 million after three years. The same crashes arrive later, on a bigger base. It ends near $1.85 million.

Same returns. Same withdrawals. A gap of roughly $1.57 million. Drop the withdrawal to $40,000 and the gap is still about $1.26 million, at roughly $867,000 against $2.13 million.

That's the sequence of returns risk chart in words. The two lines sit on top of each other with no withdrawals, then split the day spending starts.

How many years does sequence of returns risk matter?

The damage concentrates in the first decade of withdrawals. Planners often call the five years before retirement and the ten after it the retirement red zone. A bad run inside that window sets the path for everything after it.

Late losses still hurt. They just hit a smaller remaining horizon, and often a balance that has already grown.

Why is the 4% rule exposed to sequence risk?

William Bengen's 1994 study set the 4% rule by finding the worst historical starting year and working backward. So the rule already assumes a bad sequence. It's a survival floor built around the worst start in his data, which was 1966.

The weakness is that it's fixed. The rule sets a spending path on day one and ignores what markets do next. It can't respond to a crash in year two.

How to protect against sequence of returns risk

No single fix. Each approach trades something away. Here are the ones advisors actually use.

• Bucket strategy. Hold two to three years of spending in cash and short bonds. Draw from the bucket in a crash so equities aren't sold at the bottom.
• Dynamic spending rules. Cut withdrawals when the portfolio falls below a set band. Raise them when it rises above one. The Guyton-Klinger decision rules are the best-known version.
• A rising equity glide path. Start retirement with less in stocks and add equity over the first decade. Planners call it a bond tent.
• An income floor. Cover essential spending with Social Security, pensions or an annuity. Then the portfolio only funds the discretionary part.
• Systematic risk management. Use rules-based signals to cut equity exposure when conditions deteriorate, and add it back when they improve.

Which retirement income strategy addresses sequence of returns risk?

The approaches that work on it directly are the ones that change behavior after a loss. Buckets change where the withdrawal comes from. Spending rules change how much comes out. A systematic process changes what the portfolio holds before and during the decline.

That last one is where THOR works. THOR's indexes use rules-based signals on price trend, volatility and momentum. When the signals turn risk-off, the process can rotate from equities toward short-duration Treasuries. It seeks to reduce drawdowns inside the portfolio, so there's less depletion to recover from. It doesn't predict crashes. It reacts to measured conditions, by rule. The mechanism is covered in how an ETF can move to cash and trend following ETFs.

When sequence risk strategies fail

Every one of these has a known failure mode. Clients should hear it before they buy in.

• Bonds can fall with stocks. In 2022 the S&P 500 lost 18.1% on a total return basis. The Bloomberg US Aggregate Bond Index lost about 13%. A 60/40 mix gave little shelter, and buckets built from longer bonds shrank too.
• Buckets need refilling. After a long bear market the cash runs out. Refilling means selling equities, possibly still near the lows.
• Spending cuts are real cuts. Dynamic rules work because the client spends less. Some clients won't, or can't.
• Signals can whipsaw. The S&P 500 fell 33.9% from 19 February to 23 March 2020. It regained its prior high on 18 August. A rules-based process can exit late and re-enter after part of the rebound is gone. That lag is the cost of reacting instead of predicting.
• Cash costs something in good years. Every defensive move that turns out unnecessary gives up return. That's the premium for the insurance.

How do I build a sequence of returns risk calculator?

A spreadsheet does it. You need a starting balance, an annual withdrawal and a series of annual returns. Subtract the withdrawal, apply the return, repeat. Then reverse the return column and run it again. The gap between the two ending balances is the sequence risk for that client's plan. Twenty rows is enough to make the point in a client meeting.

Sequence of returns risk: definitions

• Sequence of returns risk. The risk that the order of returns, not their average, depletes a portfolio that is funding withdrawals.
• Retirement red zone. Roughly the five years before and ten years after retirement, when sequence risk does the most damage.
• Bucket strategy. Holding near-term spending in cash or short bonds so equities aren't sold in a downturn.
• Bond tent. A glide path that lowers equity exposure around retirement, then raises it over the following decade.
• Safe withdrawal rate. The highest starting withdrawal that survived the worst historical sequence in a given study.
• Drawdown. The decline from a portfolio's peak value to its lowest point before a new peak.

Past performance is not indicative of future results. Index figures cited above are public market data, total return where stated, for illustration only. They do not represent the performance of any THOR fund or strategy, and this material is not investment advice.