Managing Sequence of Returns Risk in Retirement


It has been said that timing is everything. When it comes to drawing down your retirement savings – this is very true and any draw-down plan when the markets are tanking can be downright scary for any retiree. What is the sequence of returns risk? How might any sequence of returns risk impact your retirement plan?  How do you go about managing sequence of returns risk?

Read on to find out!

As luck would have it: What is Sequence of Returns Risk?

The sequence of returns risk can be a beauty or a beast in that the market can deliver returns both ways – positive or negative.

As you already know from our site, any investor in their asset accumulation years should be cheering for a market decline or some form of prolonged negative returns. This allows investors to buy your stocks on sale per se. Read on: Four Keys to Investing Success.

In retirement, however, you’re probably not celebrating a market crash whatsoever. That’s because if the market declines significantly, early and often at the start of your retirement drawdown years, those market drops can have a huge impact on how long your nest egg might last. Once an investor retires and starts potentially drawing down their investment portfolio, annual market returns become critically important. Significant losses in the early years of retirement (definitely within the first five (5) years) can dramatically reduce the longevity of a portfolio, even if great market returns occur in the years later on…

This truth was initially discussed in this post: The Truth about Retirement Income Planning.

In today’s post, we’ll share the huge irony that comes with the sequence of returns risk.

How to understand Sequence of Returns Risk

As investors, we face common challenges when we enter retirement. We want firm answers to questions like:

  • How long will my money last?
  • Will I run out of money?
  • How can I protect my retirement savings?

You already know from your asset accumulation years that markets can crash, sometimes significantly and quickly. Recall last year? Yikes!

When markets crash, you can also face a double-whammy as an equity investor: higher inflation can also eat into your returns. We are seeing this play out in real-time now.

Also called sequence risk, what we are talking about is the risk that comes from the order in which your investment returns occur. Since timing is everything, you can appreciate that if the market is down and you must draw down your retirement nest egg at the same time, the longevity of your portfolio might be in question.

The good news is, market returns can cut both ways. For every downside, there is often an upside. Based on the compounding nature of wealth, when the sequence of returns is good, then your wealth can actually produce tremendous returns which can more than offset any future or even prolonged negative returns! The irony with sequence of returns is there can be extraordinary growth from early, positive returns, in retirement.

How Does Poor Sequence of Returns Impact your Retirement Plan?

As always, the answer is:  it depends!

There is however a mathematical reason beyond that answer since when negative returns occur near the outset of retirement, the investor is left with a smaller base on which future positive returns can compound. Over time, in the early retirement years, that portfolio value may continue to decline with every retirement income withdrawal.

Essentially you see the problem: you have a hole in your retirement income bucket and you’re taking assets out of that bucket at the same time!

Let’s look at an example using two different worst-case 10-year market scenarios.  Under both scenarios, the returns are identical, except in reverse order. We did that to demonstrate the risk we are talking about even though the average rate of return for each scenario is the same.  Take notice of the negative returns in years 1 and 2 at the start of retirement in Scenario B.

Scenario A ReturnsScenario B Returns
Year 112.70%-14.20%
Year 22.04%-0.02%
Year 3-3.87%13.27%
Year 4-6.94%9.81%
Year 511.56%8.55%
Year 68.55%11.56%
Year 79.81%-6.94%
Year 813.27%-3.87%
Year 9-0.02%2.04%
Year 10-14.20%12.70%

Consider our assumptions for each scenario for a sequence of returns risk:

  • We start retirement with a hypothetical $700,000 RRSP balance, with 60% stocks and 40% bonds.
  • No TFSA savings, no workplace pension.
  • Some cash/small cash wedge* of $25,000 exists. (We’ll come back to the *cash wedge concept in a bit.)
  • Luckily, our retiree has pretty much full CPP at age 70 and OAS at age 65.
  • This retiree spends $45,000/year after-tax which can increase with inflation (we used 2%).
  • The returns repeat every 10 years.

You can read everything about the Canada Pension Plan (CPP) and Old Age Security (OAS) in these posts below, including why many of our clients consider deferring these government benefits to fight longevity risk and sequence of returns risk.

Even though the average returns over the 10 years are the same between Scenarios A and B, the outcomes are different.

Under scenario A, using our retirement projection tools and the returns indicated in the table above under Scenario A, the retiree is able to meet their spending goals with their portfolio lasting until age 95.

Here is a graphical display of their sources of income over the years.

sequence of returns risk 1

Under scenario B, using our retirement projection tools and the returns indicated in the table above under Scenario B, even though the average returns are the same as Scenario A, the portfolio starts off on a bear market that results in negative returns for the first couple of years. In this scenario, their RRSP lasts until 90 a full 5 years less.  While age 90 is still well above the average lifespan of a Canadian, the point is that the RRSP did not have the same longevity as Scenario A above.

Of course, these are just simple examples. We have no way of knowing in advance how any sequence of returns risk could actually play out. Given any financial future is unknown, we need to plan for some sequence of returns risks. A poor sequence of market returns could very well happen and it could be worse than scenario B!

How to go about Managing Sequence of Returns Risk?

At Cashflows & Portfolios, we feel there are a few ways to mitigate the sequence of returns risk. Let’s look at a few!

1. Use the 4% safe withdrawal rule – maybe!?

You also know from our site the 4% rule comes from a 1994 study by financial advisor William Bengen, who evaluated retirement portfolio withdrawals over multiple decades. Bengen wanted to see, based on historical returns at least, what an initial and sustained safe withdrawal rate would be based on historical market conditions and inflation rates.

To summarize, Bengen found an initial withdrawal rate of 4% from the portfolio value, adjusted for inflation each year thereafter, provided about 30 years of income – without fear the portfolio would be depleted/fully exhausted. Bengen found the 4% rule worked in all market conditions – through crashes, corrections, wars, inflation, stagflation and more!

This historical study was interesting in that:

  • For a 30-year retirement, the 4% rule seems rather “safe” to use, but
  • Some retirement periods may last longer than 30-years, and
  • Using this rule, while you may not run out of money in any 30-year period, some 4% rule scenarios actually leave you with ironically huge sums of money at the end of your life – thanks to a positive sequence of returns.

Retirement expert Michael Kitces does work outstanding work in this area, debunking any hard and fast use of the 4% rule and much more. Check out his articles and this particular post below:

The Extraordinary Upside Potential Of Sequence Of Return Risk In Retirement.

Personally, we don’t really like the 4% rule, especially for any early retiree.

Read on why here: Why the 4% rule doesn’t work for FIRE!

2. Have some Fixed Income in your Portfolio during Retirement

Having some fixed income in your portfolio during retirement can really reduce the impact during a poor sequence of returns during a bear market.  In our example above, we used a 60% equity 40% fixed income/bonds portfolio which helped limit the impact of negative return years.  What if the retiree above maintained 100% equities during retirement?

  • Under Scenario A:  A 100% equity allocation resulted in full exposure to the bear market which resulted in the RRSP lasting until age 87 compared to age 95 with a 60/40 portfolio.
  • Under Scenario B:  Combined with a high equity allocation, and low returns at the beginning of retirement resulted in the RRSP lasting until age 82 compared to age 90 with a 60/40 portfolio.

3. Use income products to help you with longevity and overcome sequence of returns risk

While having substantial assets at the end of life doesn’t seem like a problem, thanks to a positive sequence of returns.  However, running out of money in retirement remains a primary concern for many.

So, there are products that can help with that, like insurance annuities and other creative funds – like the recently announced Longevity Pension Fund.

At a high level, this mutual fund is a cross between a balanced index mutual fund (47% equities/38% fixed income/15% alternatives), an annuity, and a defined benefit pension. The fund’s main features include:

  1. Income for life, but without the guarantees. As mentioned, the Longevity Purpose Fund is a mutual fund that any investor will be able to buy. Once purchased, and the investor is 65 or older, the fund will pay a distribution for life (at least that is the plan).  Purpose Investments (the manager of the fund) has stated that the 6.15% yield may sound high, but to maintain that yield they would only need to achieve an annual return of 3.5% net which is well below historical returns for a 60/40ish portfolio. Combined with mortality credits (investors who die sooner than expected), Purpose Investments has stated that 6.15% is conservative and can possibly go higher in the future. On the flip side, the distributions are not guaranteed and if there is a severe bear market, the yield could potentially be reduced (or even eliminated).
  2. You can get some of your investment back. With annuities and defined benefit pensions, you don’t typically get your contributions back. With this Longevity Fund, if you sell the fund you will get your initial investment minus any income payments. For example, if you have invested $100k into the fund, and have been paid out $10k, then you get back $90k if you sell.  At a yield of 6.15%, essentially you can get some capital back up to 16 years of being invested in the fund. After that point, consider yourself invested for life.
  3. The taxation of the distributions will be tax efficient. The Longevity Fund will pay out about 50% return of capital and the remaining will be a mix of capital gains, dividends and interest. This means that in a taxable investment account, the distributions will be tax-efficient (much more so than a defined benefit pension payment).

Those are three great interesting features about this fund. We, however, have some concerns with this product. Check out why we are skeptical of income funds and in particular, some initial caution with this product:

4. Use a Variable Percentage Withdrawal (VPW) approach

As you know, under the 4% rule, retirees withdraw 4% of their portfolio in year 1 (of retirement) and then adjust this amount going forward based on the rate of inflation. For 30-years or so!

A better, more realistic approach, is to use dynamic spending rules – a variable percentage withdrawal (VPW) approach.

What we mean is, just like your asset accumulation years, we have little doubt every month had the same expenses/spending plan. Why would retirement spending be a straight line?

When market returns are high and inflation is low, retirees can distribute/spend more from their portfolios. When market returns are negative and inflation is higher than expected (like now?), retirees can reduce/spend less from their portfolios. VPW is essentially that.

Check out My Own Advisor’s post on VPW here. 

We believe this is a great approach for the following reasons:

  • VPW combines the best ideas associated with other strategies – adapting your withdrawals to market/portfolio returns so effectively you don’t draw down your portfolio too quickly.
  • It uses a variable, and an increasing percentage to determine withdrawals over time so effectively you don’t hoard your money “until the end”.
  • Essentially, this is one of the best approaches we know about to increase spending in “good years” and decrease spending in “bad years” therefore giving investors psychological ease.

5. Use a Cash Wedge – we intend to!

In his 1994 paper, Bengen did introduce the idea of dynamic spending rules. Bengen highlighted that even decreasing distributions/spending below the “4% rule” can have a significant impact on a portfolio’s longevity.

We believe one strategy, beyond variable spending or just spending less, is the use of a cash wedge.

Now, there are many types of cash wedges in our view.

  1. A cash wedge of cash savings and little bonds or no other fixed income.
  2. A cash wedge of cash savings, some fixed income in the form of bonds or Guaranteed Investment Certificates (GICs), and/or
  3. A cash wedge of cash savings, GICs, bond ETFs or simply bonds as part of a balanced portfolio (of stocks and bonds).

Either way, you can see a common denominator of the cash wedge approach is simply to have some cash savings in retirement – ideally ample amounts of it for a few reasons.

The goal of any cash wedge approach is to allocate a portion of your retirement portfolio, in readily available cash, to meet your income needs/spending needs, while still keeping a diversified portfolio to take advantage of market opportunities or market increases for long-term growth.

Employing a cash wedge can help you:

  1. With any sleep-at-night factor,
  2. Reduce the impacts of a sequence of returns risk,
  3. Increase portfolio liquidity (to manage large purchases/expenses), such that ultimately,
  4. You don’t need to rely on your stock (or even some bond) sales from your portfolio to deliver income/cash for retirement expenses.

For the most part, when people speak of a cash wedge they are talking about the following:

  • a portion of your retirement income (usually one year’s worth) put into conservative, highly accessible, easy to withdraw assets (such as cash, a money market fund, other), money you use as First Year Income, and
  • a portion of your retirement income (usually Second Year Income or more years’ income) into guaranteed short-term investments, such as 1-year or 2-year GICs, bond funds, bond ETFs, other secure assets including any high-interest savings account.

When GICs, other short-term assets mature, those short-term investments are used to replenish your cash needs. The cash wedge approach works because you have guaranteed income/cash to spend for 1- or 2- or even 3-or more years respectively.

What about the rest of the portfolio?

The rest of your savings (mostly stocks, a mix of stocks and bonds, other assets like real estate) is left to grow as part of your personal portfolio to help you meet future income needs throughout retirement. As profits are made from this portion of your portfolio, they are moved into cash or cash wedge positions above. Essentially, a rolling strategy overtime to avoid  “timing” problems caused by withdrawing income from less liquid portions of your retirement portfolio in times of short-term market volatility.

My Own Advisor talked about how to open up the investment taps in this cash wedge overview here. 

What approaches are we going to use?

At Cashflows & Portfolios, both founders (Mark and Joe) intend to use a combination of a cash wedge approach and VPW approach. In doing so, we believe the cash wedge/savings will buffer ourselves from short-term market volatility (for 1-2 years). By employing some VPW tactics, adjusting our expenses in good or bad market years, we believe we can adjust to market volatility for at least the same period if not up to 3-4 poor stock market years if really needed.

Need any support with your retirement income projections? Just reach out!

Knowing how to demystify the retirement income puzzle is not trivial work but it’s absolutely something we can help with. If you need some help solving your retirement decumulation puzzle (i.e., how to efficiently withdraw from your retirement accounts), or figuring out if you have enough saved to spend for your retirement income plans, we’re here to help answer those questions and more!

If you are interested in obtaining private projections for your financial scenario, please contact us here to get started.

Thanks for your ongoing readership and for sharing this site with others. We feel our site and services are totally unique in Canada and we appreciate all the feedback!

Other case studies:

  1. You can carry a mortgage into retirement – if you have a great plan. Read on in this early retirement case study.
  2. Can this individual retire on a lower income including using GIS?
  3. How much do I need to save to retire at age 60?

Disclaimer: Any information shared on our site (“Cashflows & Portfolios” or related to our site, is for awareness and illustrative purposes only. 

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4 thoughts on “Managing Sequence of Returns Risk in Retirement”

  1. An interesting approach but I have some concerns with the scenario. I doubt the average person has a $700,000 RRSP portfolio. I am sure many do, however most don’t. The fact that many (55% +) don’t have a work pension plan, so recurring and increasing cashflow is paramount.
    Once a RRSP hits 70 it’s RRIF time which means a set and increasing min. withdrawal every year based on the account total dec 31 of the previous year. On smaller RRIF balances capital preservation is paramount to drive future and growing income needs. Although over the lifetime of the RRIF selling securities will be required these sales will deplete the income creation ability.
    Although the charts are nice graphically, you don’t really mention how much is withdrawn from the RRSP/RRIF annually , your scenario also had close to a third (196,000) sitting in cash which seems a bit excessive but you didn’t mention their withdrawal amount so who’s to say.
    To me if you had a portfolio structured to create dividend income with high quality blue chip stocks that increase their div. annually would be the way to go. I doubt that bonds or similar investment would if at all cover inflation certainly not these days
    I realize every retirement scenario is different for each individual’s needs , but this layout 60 / 40 just seems same old/ same old.
    FYI this was posted as a constructive view , I love the discussion and topics for review that this site generates. Keep up the good work.

    • Thanks Andrew. Some constructive criticism is always good!

      Yes, true to a point, some retirees might not have $700,000 saved up inside their RRSP by age 65. We just used this number as an example. Likely $500,000 could have been more realistic per individual.

      Also, we did highlight there is no workplace pension. We agree, many Canadians do not have one!

      The drawdown ($45,000) is provided and only the cash savings grows (started at $25,000 using 2% inflation to about $45,000) by the early 80s.

      All that said…yes…we are also personal fans of a “portfolio structured to create dividend income with high quality blue chip stocks that increase their div. annually”. I suspect in future scenarios, we could very well include an asset mix beyond 60/40 which might share a different outcome!

      Curious, what is your asset mix Andrew?

      Thanks for the feedback.


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