Sequence-of-returns risk, and simple guardrails

While you're saving, a market crash is painful but survivable, and sometimes even a chance to buy at lower prices. Once you're living on your savings, the same crash is more dangerous. You're selling investments to pay the bills while prices are low, and those shares can't take part in the recovery.

That's sequence-of-returns risk: the danger that bad years arrive early in retirement. For early retirees, whose money may need to last 40 or 50 years, it's one of the biggest risks in the plan.

This is general education, not advice. The research described here uses historical data and models; it doesn't predict future markets. Please talk with a licensed professional before changing how you invest or withdraw.

A worked example

This is a made-up illustration with simple numbers, not a forecast.

Two people each retire with $1,000,000 and take $40,000 at the start of each year. Both get the same three yearly returns: +20%, +5% and −20%. Only the order differs.

Retiree A: good years first (+20%, +5%, −20%)

• Year 1: $1,000,000 − $40,000 = $960,000, grows 20% to $1,152,000.
• Year 2: − $40,000 = $1,112,000, grows 5% to $1,167,600.
• Year 3: − $40,000 = $1,127,600, falls 20% to $902,080.

Retiree B: bad year first (−20%, +5%, +20%)

• Year 1: $960,000, falls 20% to $768,000.
• Year 2: − $40,000 = $728,000, grows 5% to $764,400.
• Year 3: − $40,000 = $724,400, grows 20% to $869,280.

Same returns, same withdrawals: Retiree B is $32,800 behind after three years, and every future year's withdrawal is a bigger share of a smaller portfolio. Without any withdrawals, both would have ended at exactly $1,008,000, because multiplication doesn't care about order. It's the withdrawals that make order matter.

Stretch that over a real decade, with a real bear market, and the gap can decide whether a plan works.

Why early retirees feel it more

The 4% rule, and where it falls short explains that the classic research built its 4% figure around retirements of about 30 years. Retiring at 40 or 50 means:

• More years of withdrawals for an early slump to compound through.
• Often no pension or Social Security yet to cover part of spending in the early years. Your own Social Security retirement benefit generally can't start before 62 (SSA).
• Health insurance costs to cover until Medicare.

The good news: early retirees often have more flexibility, too. They may be able to work a little, move, or adjust spending in ways that are harder later in life.

Tool 1: the bond tent

The idea is to be most conservative right around your retirement date, when sequence risk is highest, and then slowly take more risk again as the danger window passes. Drawn on a chart, the bond share rises toward retirement and falls afterward, like a tent.

The research behind the second half of that tent is a 2014 study by Wade Pfau and Michael Kitces in the Journal of Financial Planning, "Reducing Retirement Risk with a Rising Equity Glide Path." They found that portfolios that started retirement with 20% to 40% in stocks and rose to 60% to 80% reduced both the chance and the size of failures, compared with fixed or declining stock allocations, in their models (FPA summary).

Their explanation: if bad returns come early, a retiree with a rising stock share is buying stocks gradually at lower prices, in time for the recovery. If good returns come early, the retiree is ahead anyway. The authors described it as "heads you win, tails you don't lose" (same source).

Things to keep in mind:

• It's a model result for a typical retirement, not a promise. A more conservative portfolio usually means lower expected growth.
• Their study used a 30-year retirement as its main case and also tested 20- and 40-year horizons. Early retirees planning for longer than that are extrapolating, and usually think about how long the "tent" should last relative to their own timeline.
• Moving money between stocks and bonds in taxable accounts can trigger capital gains. Many people do it inside retirement accounts, or by directing new money and withdrawals.

Tool 2: a cash buffer

Many retirees keep one to two years of spending in cash or short-term, high-quality holdings. In a bad market year, they spend from the cash instead of selling stocks, then refill it when markets recover.

Why people like it:

• It's simple and easy to understand.
• It protects behavior. Knowing next year's spending is already in the bank makes it easier to leave investments alone in a crash.

The trade-off is that cash usually earns less than stocks or bonds over long periods, so a very large buffer can drag on long-term growth. It also only helps if you have a rule for when to spend it and when to refill it. Where to keep it is covered in The emergency fund on the road to FIRE.

Tool 3: flexible spending and guardrails

The classic 4% rule assumes you take the same inflation-adjusted amount every year no matter what happens. Real people rarely spend that way, and it turns out flexibility is valuable.

In 2006, planners Jonathan Guyton and William Klinger published "Decision Rules and Maximum Initial Withdrawal Rates" in the Journal of Financial Planning. They tested, with Monte Carlo simulations, a set of rules that adjust withdrawals: cutting spending when the current withdrawal rate rises well above where it started (after poor markets), and raising it when the rate falls well below (after strong ones). Under their rules and assumptions, they reported that initial withdrawal rates of 5.2% to 5.6% were sustainable at a 99% confidence standard for portfolios with at least 65% in stocks (FPA summary).

The point isn't the exact number: their rules came with real spending cuts in bad periods, and the results depend on their assumptions. The point is that a willingness to adjust lets a plan start higher or run safer.

Simpler versions people use:

• Skip the inflation raise in a year when the portfolio fell.
• Split spending into needs and wants. Cover the needs reliably; flex the travel and extras with the market.
• Set a ceiling and a floor. Decide ahead of time what you'll cut if the portfolio drops by a set amount, and what you'll add back if it rises.

Writing the rules down before a downturn matters. It's much harder to decide calmly in the middle of one.

The levers that need no portfolio change

Some of the strongest protections against sequence risk aren't about investments at all:

• Earn a little in the early years. Even modest income means selling less when prices are down. See Earning a little in early retirement and the Barista FIRE calculator.
• Keep fixed costs low. A paid-off or modest home and few fixed bills make spending cuts possible.
• Build in a margin. A slightly lower withdrawal rate, or working a little longer, gives every other tool more room.
• Know your later income. A pension or Social Security that starts later can let you spend more freely in the early years, knowing the pressure eases. The Pension + FIRE calculator helps map that.

Next step

See your number at 4%, then try a lower rate to see how much margin a little flexibility is worth.

Work out your FIRE number →

Related: Which account do you spend first? and Dividends versus total return.