Sequence-of-returns risk explained

Sequence-of-returns risk is the risk that poor investment returns arrive at a bad time: usually just before or soon after you start drawing an income. When you withdraw money after a fall, you sell more of your investments to raise the same amount, leaving less to benefit when markets recover.

In the historical research behind the 4% rule, the retirements that fared worst generally began shortly before long periods of weak markets or high inflation.

Sequence-of-returns risk

The effect of the order of returns, rather than their average, on how long a portfolio lasts while money is being withdrawn.

If you invest a lump sum and neither add nor withdraw anything, the order of returns makes no difference to the final value. Multiplication works the same in any order: a fall of 18% followed by a rise of 15% leaves you exactly where a rise of 15% followed by a fall of 18% would.

Once money flows out each year, that symmetry breaks. Each withdrawal locks in the portfolio's value at that moment.

Both retirees withdrew exactly the same amounts and earned exactly the same returns. The weak-start portfolio ends with less than a third of the other, because its early withdrawals were taken from a shrinking pot.

Sequence risk is highest in the years around the point you stop contributing and start withdrawing. Your portfolio is at or near its largest, so a given percentage fall costs the most in pounds, and you have the longest time left for withdrawals to compound the damage.

During the years you are still saving, the effect partly reverses: falls early on, when your balance is small, let new contributions buy investments more cheaply.

None of these removes the risk. Each trades some return or flexibility for resilience.

• A lower withdrawal rate. Taking less leaves more room for a bad start. See withdrawal rates and the 4% rule.
• Flexible spending. Cutting back for a year or two after a fall reduces the amount sold at low prices.
• An accessible cash reserve. The UK's MoneyHelper describes holding one to three years of income in lower-risk funds so you are less likely to sell after a fall.
• Other income. Part-time work or a later pension can reduce withdrawals in the early years.

A steady-return expected path cannot show sequence risk, because every year is the same. Monte Carlo can, because each simulated path has a different order of returns.

The methodology explains how the sustainability and sequence-risk figures are calculated.