What Is Sequence of Returns Risk and Why Does It Matter?
The Problem
Sequence of returns risk can be a significant concern for a retirement portfolio, not because it's complex, but because it's counterintuitive.
A portfolio earning an average return of 7% annually might sustain withdrawals under certain conditions, conventional wisdom suggests. But this assumes returns are smooth and predictable. In reality, they are not. The sequence in which returns occur, not just the average, may significantly affect portfolio sustainability.
Example (illustrative):
- Scenario A: Year 1: -20%, Years 2-5: +10% each. Arithmetic average: 6%.
- Scenario B: Years 1-4: +10% each, Year 5: -20%. Arithmetic average: 6%.
If you withdraw $50,000 annually from a $500,000 portfolio (10% per year):
Scenario A outcome: The large loss in year 1 occurs while you are beginning withdrawals. Your portfolio must generate returns to sustain withdrawals, which becomes more challenging after the early loss.
Scenario B outcome: Positive returns in the early years allow the portfolio to grow despite withdrawals. The negative year occurs later when the portfolio may have more flexibility.
The key insight: The arithmetic average of annual returns can be identical, yet portfolio outcomes differ significantly based on when strong and weak returns occur relative to your withdrawals. This demonstrates why the sequence of returns matters in retirement.
For retirees with substantial portfolios relying entirely on portfolio withdrawals, sequence risk may pose a significant challenge in the critical early years.
Why the First Few Years Matter Most
When you retire and begin withdrawals, your ability to weather a market decline might be very constrained. A major downturn forces you to withdraw from a depressed portfolio, locking in losses. Your risk capacity (your portfolio's ability to absorb a shock) may be at its most limited.
Later in retirement, your circumstances change. You've survived several years of withdrawals and volatility. Your portfolio may have grown or stabilized. Your risk capacity might have changed. The period of greatest vulnerability to sequence-of-returns risk may have shifted.
This is one reason some retirement strategies use a glide path: a portfolio's role and risk capacity can change over time, and the allocation can be adjusted accordingly. Other strategies use static or declining-equity allocations based on different assumptions and objectives.
The Glide Path: A Systematic Approach to Sequence Risk
What Is a Glide Path?
A glide path is a predetermined plan to gradually shift your portfolio allocation over the course of retirement. Rather than holding the same allocation throughout retirement, you start with a defensive allocation (higher fixed income, lower equity) when sequence risk may pose a significant challenge. As time passes and you move through the critical early-retirement window, you systematically increase your equity allocation to capture growth potential.
Important: A rising-equity glide path is one approach to managing sequence-of-returns risk. Other retirement-income strategies use static allocations (maintaining the same mix throughout retirement) or declining-equity glide paths (starting with higher equity and gradually reducing it). Research supports multiple approaches depending on factors such as spending needs, guaranteed income sources, time horizon, risk tolerance, and legacy objectives. The appropriate strategy depends on your specific circumstances and priorities.
How It Works
Think of retirement as three stages, each with different allocation needs:
Stage 1 (Critical early period):
- Objective: Reduce portfolio volatility and provide assets for spending
- Allocation consideration: Higher fixed income, lower equities
- Reasoning: Sequence risk may pose a significant challenge. A diversified portfolio with higher fixed income may provide assets that can fund spending without requiring equity sales during market declines.
Stage 2 (Mid-retirement):
- Objective: Balanced growth and stability
- Allocation consideration: Moderately higher equities, adequate fixed income
- Reasoning: Sequence risk may have shifted as your portfolio has moved beyond the critical early withdrawal period. Your portfolio may have stabilized. You may have greater capacity to accept volatility.
Stage 3 (Later retirement):
- Objective: Long-term growth to guard against extended retirements
- Allocation consideration: Moderate-to-higher equities, stable fixed income foundation
- Reasoning: You may have a long time horizon ahead. Longevity risk (running out of money) becomes a greater concern than sequence risk.
Rather than rigid year markers, think of stages tied to your changing circumstances. The transition happens gradually, not in sudden jumps.
Illustrative framework (not a recommendation): A retiree with a $5M portfolio starting retirement might consider:
- Stage 1 target: Higher fixed income, lower equities
- Stage 2 target (after several years): More balanced mix
- Stage 3 target (many years in): Higher equities, adequate fixed income
Your specific allocation depends on your spending needs, other income sources, time horizon, and risk tolerance.
Why This Works
If a significant equity decline occurs early in retirement, a portfolio with a meaningful allocation to high-quality fixed income may provide assets that can be used for spending without requiring sales of depressed equities. The fixed-income allocation can provide a source of withdrawals during periods when equities are significantly below their target allocation, potentially reducing the need to sell equities at depressed prices. Following a predetermined allocation plan may help reduce emotional decision-making during market volatility.
Designing Your Glide Path: Key Decisions
Before you implement a glide path, consider these factors:
Decision 1: What's your total return target? Your total return need drives your allocation. Lower withdrawal rates generally give a portfolio more flexibility to withstand periods of poor returns, all else equal. If you need to withdraw very high percentages of your portfolio, sustaining withdrawals becomes more challenging and the appropriate strategy becomes more complex.
Decision 2: What's your time horizon? A retiree age 65 with a life expectancy of 90+ has a 25-year horizon. A retiree age 80 may have a 10-year horizon. A longer time horizon may provide more opportunity to recover from market declines, although the appropriate level of volatility depends on risk tolerance, spending needs, and financial capacity.
Decision 3: Do you have other income sources? Retirees with substantial guaranteed income from pensions or Social Security may have greater capacity to tolerate portfolio volatility because less of their spending depends directly on portfolio withdrawals. Fixed income can provide additional stability. Those relying heavily on portfolio withdrawals may need to balance spending needs, portfolio risk, and expected returns more carefully.
Note: High-net-worth individuals and families with pensions may maintain large portfolios because spending is high; pension income alone may not cover lifestyle expenses.
Decision 4: What triggers a glide path adjustment? Some retirees adjust regularly. Others adjust only when significant life events occur. Define your rules upfront to avoid emotion-driven decisions.
Decision 5: How granular do you want to be?
- A simple glide path: Broad targets with general flexibility.
- A detailed glide path: Specific allocation percentages, duration targets, rebalancing rules.
- A moderate approach: Clear targets with flexibility for life circumstances.
Implementing Your Glide Path: Rebalancing Discipline
A glide path only works if you follow it consistently. On a regular schedule, review your current allocation against your glide path target. If you've drifted significantly (e.g., equities are now higher than your target), rebalance.
Rebalancing in Down Markets
This may be particularly challenging. When equities are down, rebalancing involves moving money from fixed income into equities, which means you are purchasing equities when their prices have fallen relative to your target allocation. Psychologically, this feels counterintuitive when markets are declining. Maintaining this discipline through multiple market cycles is central to the strategy's approach.
Rebalancing in Up Markets
When equities are up, rebalancing forces you to trim equities and increase fixed income. This also feels counterintuitive but is essential discipline.
When to Adjust (Not Abandon) Your Glide Path
Certain events warrant re-examination:
- Major windfall or inheritance: Your spending needs change.
- Significant health or life event: Time horizon or goals may shift.
- Tax law or regulatory change: Your planning assumptions change.
- Spending needs materially increase or decrease: Your return target changes.
The key is staying committed to the discipline. Adjust your glide path only after careful reflection on whether your circumstances have fundamentally shifted.
Total Returns vs. Income-Focused Approaches
Some retirees focus on yield: they want a portfolio that generates cash from dividends and interest, with the goal of "living off the income."
This may backfire. Yield-seeking may mean overweighting fixed income and certain dividend stocks, which might lock you into a conservative allocation regardless of your time horizon. Higher-yield investments may carry different risk characteristics than their yields might suggest.
The total return approach is different:
One approach is to shift from focusing on where your returns come from (dividend, interest, capital appreciation) to total portfolio growth. Your allocation generates total returns. You withdraw what you need regularly regardless of the return composition.
Example (illustrative): A $5M portfolio with a target mix of higher fixed income and lower equities may generate:
- Fixed income portion: return through interest and price movements
- Equity portion: return through dividends and price appreciation
- Blended total return: Varies with market conditions
You withdraw what your plan requires regardless of which portion generates the return.
Why this matters for your glide path: Your glide path targets allocation, not income. As you shift over time, your total return profile changes, which supports your spending needs. This keeps you flexible and adapts to changing circumstances.
Glide Path vs. Static Allocation: A Comparison
Static allocation (maintaining the same allocation throughout retirement):
- Pros: Simple, easy to monitor, consistent exposure, less frequent trading and decision-making
- Cons: Does not explicitly adjust risk exposure as circumstances change, may not align with retirees whose risk capacity changes materially over retirement
Glide path (shifting over time):
- Pros: Adapts to changing circumstances; reduces sequence risk early; increases growth potential later; enforces discipline
- Cons: Requires monitoring; requires commitment to rebalancing when markets move against you
Hybrid approach: Maintain broad targets (e.g., keep fixed income allocation within a range) while allowing gradual shifts based on time horizon and life circumstances. Less aggressive than a full glide path, but more adaptive than completely static.
Monitoring Your Glide Path Over Time
Regular check-ins: Review your allocation quarterly or annually against your glide path targets. Rebalance if you've drifted significantly.
Periodic deep-dive reviews: Beyond rebalancing, ask bigger questions:
- Are your spending needs changing?
- Has your time horizon shifted?
- Have market conditions materially changed your asset base?
- Do you still believe in your glide path, or do circumstances warrant a reset?
Avoiding reactive changes: Resist the urge to overhaul your glide path based on headlines or short-term market moves. A glide path is a multi-year commitment. The discipline only works if you follow it.
Deeper Dives: The Full Series
This post covers the framework. The Retirement Income Strategy Series includes four additional posts that dive deeper into specific tactics: bond ladder construction, glide path implementation, rebalancing mechanics, and fixed income strategy.
For related strategies beyond this series, explore:
→ Related strategyTax-Efficient Asset Location → → Related seriesRoth Conversions and Tax Coordination →Beyond Asset Allocation: Other Approaches to Sequence Risk
Asset allocation is one way to address sequence-of-returns risk, but it is not the only approach. There are other strategies including:
- Flexible spending: Adjusting spending downward after poor market returns can materially reduce sequence risk and extend portfolio sustainability.
- Guaranteed income: Using pensions, Social Security, or annuities to cover essential expenses means portfolio withdrawals can be more flexible.
- Portfolio diversification: Holding assets that behave differently under various economic conditions provides more portfolio stability.
- Spending reserves: Maintaining cash or stable-value reserves reduces the need to sell equities after market declines.
- Phased retirement: Working longer or transitioning to part-time work reduces portfolio withdrawal pressure during the critical early years.
Many retirees benefit from combining multiple approaches rather than relying on asset allocation alone. The appropriate combination depends on your spending flexibility, guaranteed income, time horizon, risk tolerance, and personal circumstances.
The Bottom Line
Sequence-of-returns risk can be particularly important for retirees whose spending depends heavily on portfolio withdrawals, especially in early retirement. The timing of market returns matters alongside the average return.
A rising-equity glide path is one approach to managing this risk by adjusting portfolio allocation over time. Other approaches include static allocations, declining-equity glide paths, spending flexibility, and strategies that combine asset allocation with other techniques.
No single approach is universally appropriate for all retirees. The effective strategy depends on your specific circumstances: your spending needs, guaranteed income, time horizon, risk tolerance, and priorities.
For advice tailored to your specific situation, a financial advisor can help you evaluate different approaches and design a strategy aligned with your circumstances and goals.