Sequence-of-Returns Risk at the Start of Retirement
A market decline combined with early withdrawals erodes capital: plan a reserve for the first years.
In this article
Two retirements with identical average returns can end hundreds of thousands of dollars apart, depending only on the order of the years. This is sequence-of-returns risk. It is concentrated at the start of drawdown, when capital is at its maximum. Every sale during a decline then locks in a permanent loss, since units sold at a discount no longer take part in the recovery. The defence is not to predict markets, but to reduce forced sales. Build a reserve of two or three years of withdrawals in liquid deposits and short-term instruments, which funds withdrawals while a decline works itself out. Lean on guaranteed income that covers the essentials, which shrinks the mandatory withdrawals accordingly. Adopt a flexible rule that postpones postponable spending after a bad year. The allocation keeps equities, since a thirty-year retirement needs growth, but you are never forced to sell them at the wrong moment. This article prices the risk on twin cases and explains how to build these three defences.
Identify the withdrawals of the first years
Sequence risk rests on a simple fact. Two retirees who earn the same average return over thirty years can end up in opposite situations, depending on the order in which those returns arrive. Bad years at the start, combined with withdrawals, deplete capital in a way that no later return recovers. The first five years of drawdown therefore concentrate most of the risk. Start by putting a dollar figure on the withdrawals planned for those specific years. That amount, not the portfolio's total value, is what is exposed to the bad scenario.
Understand why selling deepens the decline
A portfolio that falls 20% recovers if left alone. The same portfolio, from which $40,000 is withdrawn during the trough, sells units at depressed prices, and those units never take part in the recovery. The remaining capital is then durably smaller, and each later withdrawal is a higher percentage of the balance, which speeds up depletion. This mechanism does not exist during accumulation, when you buy instead of selling. That is why the same investment strategy behaves differently before and after retirement.
Build a reserve that avoids selling
The most direct defence is to hold the equivalent of two to three years of withdrawals in cash or very short-term investments. This reserve funds the withdrawals during a decline, and the rest of the portfolio can recover untouched. You replenish it in positive years, out of the gains. The reserve has a cost: the lower return on that portion. It is the price of insurance against the one risk that can permanently compromise an otherwise reasonable retirement plan, and it is easy to calculate.
Adjust the allocation without predicting markets
The second defence is structural: reduce the equity share in the years around retirement, then let it rise gradually once the critical period has passed. This path is counterintuitive, since it raises risk with age, but it protects the period when vulnerability is greatest. Flexible withdrawals complete the arrangement: cutting discretionary withdrawals by 10 or 15% during a bad year has an effect comparable to a reserve. None of these measures requires forecasting markets, and that is exactly their appeal.
Quebec scenario
Two colleagues in Trois-Rivières retire a year apart. Their portfolios are identical, $600,000, and they withdraw the same $30,000 a year. Ten years later, one still holds $580,000 and the other $390,000. Neither made a mistake. Only the sequence of returns differs: the second took a 25% drop in his first two years. A planner shows this example to a future retiree from the same plant, to illustrate the risk specific to the start of drawdown. Selling during a decline turns a temporary dip into a permanent loss, because units sold at a discount no longer take part in the recovery. The first years weigh disproportionately, because the capital is at its maximum then. The defence is not to predict markets, but to reduce forced sales. His plan takes shape like this. First, three years of withdrawals in liquid deposits and short-term instruments, a reserve that lets him wait out a recovery without selling stocks. Second, guaranteed income, meaning public plans and an employer pension, which already covers essential expenses. The reserve only has to carry the discretionary lifestyle. Third, a flexible withdrawal rule: after a bad year, he postpones the spending that can be postponed. The allocation, reviewed without a crystal ball, keeps equities for the twenty-five years still to fund. The future retiree leaves with a sentence to put on the wall: average returns come true over thirty years, but retirement is decided by the order in which they arrive.
Checklist
- Price the first years' withdrawals
- Build two or three years of liquid reserve
- Cover the essentials with guaranteed income
- Write the postponable-spending rule
- Postpone the postponable after a bad year
- Keep equities for the decades still to fund
- Refuse any forced sale into a decline
- Draw from the reserve during troughs
- Rebuild the reserve during recoveries
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