If two investments have the same average annual return, will they produce the same retirement outcome?
While you are still accumulating assets before retirement, the long-term average return is an important measure. However, once you retire and begin making regular withdrawals for living expenses, the average return alone cannot accurately determine how long your savings will last.
If a major loss occurs early in retirement, you must withdraw living expenses from an already reduced portfolio. Even if the market later recovers, rebuilding your savings becomes more difficult because future returns are applied to a smaller amount of principal.
This phenomenon, in which the same set of returns produces different final balances depending on the order in which those returns occur, is called sequence of returns risk.
What Is Sequence of Returns Risk?
Sequence of returns risk is the risk that the order of market gains and losses during an investment period will affect the final value of your assets.
If there are no additional contributions or withdrawals, the same returns will produce the same final compounded result even when they occur in a different order. This is because the same returns are being multiplied together.
The outcome changes, however, when you make regular withdrawals for living expenses during retirement. If you withdraw money after a major market decline, you may have to sell more investments at reduced prices. As a result, you are left with fewer assets and less principal to benefit from a market recovery.
Therefore, retirement planning must consider not only Understand the difference between nominal and real returns, but also the order in which returns occur.
An Example of How the Same Average Return Can Produce Different Outcomes
The following is a simplified example designed to explain sequence of returns risk.
- Starting retirement savings: KRW 100 million
- Annual withdrawal at the end of each year: KRW 10 million
- Annual returns: -20%, -10%, +10%, +20%, and +30%
- Taxes, fees, and inflation are excluded.
The simple average annual return over the five years is 6%. Without withdrawals, the portfolio would be worth approximately KRW 123.55 million after five years regardless of the order of the returns.
Example A: Losses Occur Early in Retirement
Order of returns:
- Year 1: -20%
- Year 2: -10%
- Year 3: +10%
- Year 4: +20%
- Year 5: +30%
If KRW 10 million is withdrawn at the end of each year, approximately KRW 52.35 million remains after five years.
Example B: Gains Occur Early in Retirement
Order of returns:
- Year 1: +30%
- Year 2: +20%
- Year 3: +10%
- Year 4: -10%
- Year 5: -20%
Even with the same annual withdrawal of KRW 10 million, approximately KRW 80.93 million remains after five years.
Both examples have the same starting balance, total withdrawals, and annual returns. The only difference is the order in which the returns occur, yet the portfolio balances differ by approximately KRW 28.58 million after five years.
This example is not a prediction of the future performance of any particular investment product. It is a simplified calculation intended to illustrate the difference that can occur when investment returns and retirement withdrawals interact.
Why Is a Market Downturn More Dangerous Early in Retirement?
Losses that occur early in retirement have two effects at the same time.
First, the value of your investments declines. Second, withdrawing living expenses from the reduced portfolio leaves even less principal available to participate in a future recovery.
In particular, plans based on the 4% retirement withdrawal rule, which involves withdrawing funds at a fixed annual rate, may produce different outcomes depending on market conditions early in retirement and changes in actual spending.
For example, if a KRW 100 million portfolio falls by 20%, its value declines to KRW 80 million. If you then withdraw KRW 10 million for living expenses, only KRW 70 million remains.
For KRW 70 million to grow back to KRW 100 million, a return of approximately 42.9% is required. A 20% gain following a 20% loss does not restore the portfolio to its original value.
Factors That Increase Sequence of Returns Risk
1. Large Withdrawals Early in Retirement
If spending rises sharply immediately after retirement because of travel, relocation, a vehicle purchase, or other major expenses, you may have to withdraw more money from a declining portfolio.
2. A Portfolio Concentrated in Particular Assets
If your portfolio is concentrated in a few stocks or a particular industry, the volatility of your entire retirement portfolio may increase during a market downturn.
3. Insufficient Funds Reserved for Living Expenses
If all immediate living expenses must be withdrawn from volatile investments, it may be difficult to avoid selling assets during a market decline.
4. An Inflexible Spending Structure
When essential fixed expenses are high, it can be difficult to reduce withdrawals even when market conditions are unfavorable.
5. A Plan That Does Not Account for Inflation and Costs
If you calculate only investment returns while excluding inflation, taxes, and fees, you may overestimate the amount of retirement savings that will actually be available to spend.
Five Ways to Reduce Sequence of Returns Risk
1. Set a Conservative Initial Withdrawal Amount
Rather than withdrawing the largest possible amount from the first year of retirement, separate essential living expenses from discretionary spending and set an appropriate initial withdrawal amount.
A fixed withdrawal rate is not equally suitable for everyone. Your retirement period, assets, pension income, spending structure, and investment risk must all be considered together.
2. Adjust Discretionary Spending During Market Downturns
FINRA explains that retirees should avoid excessive spending early in retirement and be prepared to reduce discretionary expenses in years when their investments experience losses.
Temporarily reducing adjustable expenses such as travel, hobbies, and expensive purchases can reduce the amount of investments that must be sold after a market decline.
3. Separate the Living Expenses Needed in the Near Future
Separating living expenses that will be needed in the near future from assets intended for long-term investment can reduce the need to fund every expense by selling volatile assets during a market decline.
However, holding too much cash and too many low-risk assets may cause your savings to fall behind inflation over the long term. The appropriate allocation should therefore reflect your retirement period and spending plan.
4. Diversify Your Assets and Review Them Regularly
Diversifying across assets that behave differently, such as stocks, bonds, and cash equivalents, may help reduce the effect on your overall portfolio when one asset class experiences a major decline.
Diversification cannot completely prevent losses. Your asset allocation should be reviewed regularly to ensure that it remains appropriate for your investment period and risk tolerance.
5. Consider Inflation and Real Returns Together
Retirement living expenses can change over time. At this point, the calculation should also include how inflation affects retirement savingsHow inflation affects retirement savings, so you can determine whether today’s withdrawal amount will still be sufficient in the future.
Instead of looking only at the nominal return shown on your account, review your retirement plan using the real return after accounting for inflation, taxes, and fees.
What to Check Before Withdrawing Retirement Savings
- How much do you need each month for essential living expenses?
- Do you have a regular source of income, such as a pension or rental income?
- How much discretionary spending could you reduce during a market downturn?
- Have you separated money needed in the near future from assets intended for long-term investment?
- Is your portfolio overly concentrated in a particular investment product or industry?
- Do your expected returns account for inflation, taxes, and fees?
- Do you have a clear rule for adjusting withdrawals during a market downturn?
If you calculate your retirement savings using only an average return without answering these questions, it may be difficult to maintain your plan when actual market volatility occurs.
Should You Avoid Investing Because of Sequence of Returns Risk?
The existence of sequence of returns risk does not mean that you should hold all your retirement savings in cash.
As retirement lasts longer, inflation can reduce purchasing power, so some level of asset growth may be necessary. On the other hand, concentrating too heavily in volatile assets while pursuing only high returns can increase the risk of major losses early in retirement.
The goal is not to predict the direction of the market, but to build a financial structure that allows you to cover living expenses and maintain your long-term plan even when losses occur.
ConclusionConclusion
Sequence of returns risk is a major retirement risk that cannot be identified by looking at average returns alone.
Even when the same annual returns apply, the final portfolio balance can be significantly different if losses occur early in retirement while withdrawals for living expenses continue.
When planning your retirement savings, consider not only the average return but also the initial withdrawal amount, the flexibility of your living expenses, asset allocation, inflation, taxes, and fees.
This article is intended to provide general financial information and does not recommend any particular investment product or asset allocation strategy. Investment and retirement withdrawal decisions may vary depending on an individual’s financial circumstances, investment period, and risk tolerance.
References
FINRA, Managing Your Retirement Portfolio
U.S. Department of Labor, Taking the Mystery Out of Retirement Planning
Investor.gov, What Is Risk?