Sequence of returns risk: why the first years of retirement decide the rest
Sequence of returns risk means a market fall in your first years of retirement does far more damage than the same fall later on. People who retire early are more exposed to it. Here is how big the effect is, and what you can do about it.
Two people retire at 50 with €1 million each. Same investments, same spending, and over the next 40 years, the same yearly returns, just in a different order. One of them runs out of money at 83. The other is still fine at 90, with more than €800,000 left. The only difference is the year the market crashed: in the first year of retirement for one, in the twentieth year for the other. That is sequence of returns risk.
Why the timing matters
If you just leave your money invested, without adding to it or taking anything out, the order of good and bad years makes no difference to where you end up. A 30 percent fall followed by good years ends at the same place as good years followed by a 30 percent fall. It is only when you start living off your savings that the order starts to matter.
Here is why. Say you need €40,000 for the year and your investments have just fallen 30 percent. To raise that €40,000 you have to sell what was worth about €57,000 a year ago. Those shares are gone. When prices recover, they recover without them, so you are climbing back with less.
A fall late in retirement does less harm, for two reasons: your savings have had decades to grow first, and there are fewer years left to pay for. A fall early on hits the money that still has to last you the longest.
Same crash, different year
The easiest way to see it is to keep everything the same and move one bad year around. Start with €1 million and spend €40,000 a year. That is 4 percent of your savings, the well-known rule of thumb for how much you can take out each year. Let your investments grow 5 percent a year above inflation, except for one year where they fall 30 percent. Then change only which year the fall happens.
| Year of the 30% fall | What happens over 40 years |
|---|---|
| Year 1 | money runs out in year 34 |
| Year 3 | money runs out in year 38 |
| Year 5 | just lasts, about €46,000 left |
| Year 10 | lasts, about €381,000 left |
| Year 20 | lasts, about €848,000 left |
| Year 30 | lasts, about €1.13 million left |
| No fall at all | lasts, about €1.97 million left |
All amounts in today’s money. €1 million at the start, €40,000 taken out at the start of each year and raised with inflation, returns of 5 percent a year above inflation apart from the one fall. If you took nothing out, every row would end at the same €4.69 million.
Every row has exactly the same returns, just in a different order. A fall in year one empties the account six years early. The same fall in year twenty still costs something, but the money lasts with plenty to spare. Real markets are messier than one bad year in an otherwise steady line, of course. But the pattern holds: the danger sits mostly in the first ten years, and most of all in the first few.
Why early retirees are more exposed
Anyone who lives off their savings faces this. Retiring early makes it worse in two ways.
- A longer retirement. Stop at 50, plan to 90, and the money has to last 40 years, not the 30 the 4 percent rule was tested on. An early loss has more years to hurt you. We went through what that means for how much you can safely take out in the 4% rule, for people who don’t retire in America.
- No other income yet. State and workplace pensions often start in your sixties. Until then your savings pay for everything, so the years when they are most exposed are also the years with nothing else to fall back on. More on that gap in your pension doesn’t count until you can touch it.
If your investments are in one currency and you spend in another, there is a third: a falling market and a bad exchange rate can hit in the same year. We covered that in which currency do you spend from.
What you can do about it
You can’t choose when the bad years come. You can choose how much they hurt. We tested each of these on the worst case above, the fall in year one, where the money runs out in year 34.
Take out a little less
Take 3.5 percent a year instead of 4: €35,000 instead of €40,000. With the same fall in year one, the money now lasts all 40 years with about €336,000 left. This is the most dependable fix, and the most expensive. To spend €40,000 a year at 3.5 percent, you need about €1.14 million saved instead of €1 million, so you work longer before you stop.
Spend less while you are behind
Spend 10 percent less in any year your savings are below what you started with. With the fall in year one, the money lasts all 40 years with about €193,000 left. So being flexible works. But know this before you count on it: in this example, the savings stay below where they started for the rest of the 40 years, so the cut lasts almost the whole retirement. After a big early fall, “spend less in bad years” can mean spending less for a very long time, not just one tight year.
Keep some cash to live on
Keep one to two years of spending in cash. When the market falls, you live on the cash and leave your investments alone, then top the cash back up once prices recover. That way you avoid selling at low prices, which is exactly how sequence risk does its damage. The cost is that cash earns very little, so keeping too much of it slows your growth in normal years. This is separate from your emergency fund, which is for life’s surprises like a broken boiler or a medical bill, not for market falls. We covered how big that one should be in how big should your emergency fund be.
Earn a little in the first years
This one is easy to overlook. Earn €15,000 a year for the first five years, from part-time work, freelancing or anything else, and you only need to take €25,000 a year from your savings in that time. With the fall in year one, the money then lasts all 40 years with about €158,000 left. A small income early on does more than a bigger one later, because it cuts your withdrawals in exactly the years when they do the most harm.
How fjordFIRE handles this
On fjordFIRE’s FIRE page, your plan is run through a thousand possible futures. Each one has good and bad years in a different order, the way real markets behave, and the page shows how often your money lasts. So you see the range of outcomes, including the unlucky ones, instead of a single average.
Your emergency fund sits in the Protect section, shown as the number of months it would cover, so you can see how long you could go without selling. And you set your own withdrawal rate, so you can watch what moving from 4 to 3.5 percent does to your number and to your odds.
Read next: The 4% rule, for people who don’t retire in America · You hit your number. Which currency do you spend from?
Go deeper: Lesson: The 4% Rule & Sequence Risk.
Companion tools: FIRE Number calculator · Emergency Fund calculator.
Common questions
What is sequence of returns risk?
It is the risk that the bad years in the market come at the wrong time. Once you live off your savings, a fall in your first years of retirement hurts much more than the same fall later, because you have to sell investments while prices are low, and what you sold is not there when prices recover. Two people can earn the same average return and end up in very different places, only because the good and bad years came in a different order.
Why is sequence risk bigger for early retirees?
Two reasons. The retirement is longer, often 40 or 50 years instead of 30, so an early loss has more years to hurt you. And in the first years there is usually no other income: state and workplace pensions often only start in your sixties, so your savings pay for everything at exactly the time they are most exposed.
How long does the danger window last?
Roughly the first ten years, and the first few matter most. In our example, a 30 percent fall in year one or year three makes the money run out before the 40 years are up, a fall in year five only just gets through, and from year ten onward the plan holds with plenty left.
What withdrawal rate protects against sequence risk?
For a retirement of 40 to 50 years, research on past market returns points to roughly 3 to 3.5 percent of your savings a year, instead of the well-known 4 percent. In our example, taking 3.5 percent instead of 4 turns a plan that runs out in year 34 into one that lasts all 40 years. The cost is that you need about 14 percent more saved before you stop.
Does a cash reserve help with sequence risk?
Yes, if it is sized sensibly. One to two years of spending in cash lets you live on the cash during a fall instead of selling investments at low prices, and you refill it once markets recover. The trade-off is that cash earns very little, so a very large reserve slows your growth in normal years.
Does sequence risk matter while I am still saving?
A little, and the other way round. While you are still adding money, a fall near the end of your saving years, when your savings are biggest, hurts more than one at the start. But the risk is much bigger once you start withdrawing, because then a fall forces you to sell.