Sequence-of-Returns Risk: Why the Order Matters

Sequence-of-returns risk is the danger that the timing of good and bad years - not just their average - determines how long your money lasts. It matters whenever you are adding money to a pot or taking money out of it. For a retiree drawing an income, a run of poor returns in the first few years is disproportionately damaging: every withdrawal in a falling market permanently removes units you can never buy back, so there is less capital left to recover when markets rebound.

The key word is path-dependence. Most people are taught to think about investing through the average, or the compound annual growth rate. That single number is a summary that throws away the one thing that matters most when you are living off the pot: the shape of the journey.

Here is the counter-intuitive part. If you never add or remove money, order does not matter at all. Multiplying by 1.2 then 0.8 gives exactly the same result as multiplying by 0.8 then 1.2, because multiplication is commutative. A lump sum left completely untouched ends up in precisely the same place regardless of the sequence.

Cash flows break that symmetry. The moment you withdraw a fixed pound amount each year, a fall early on shrinks the base that every later return compounds from. This is really a lesson about ergodicity - the average outcome across many parallel investors (the ensemble average) is not the same as the outcome you actually live through over time (the time average). The advertised average return is an ensemble statistic; your pension is a single path.

Meet two retirees, Ada and Ben. Both retire with a pot of £500,000 and withdraw £25,000 at the end of every year to live on. Both earn the exact same five annual returns - a nasty crash, a mild fall, and three good years: -30%, -10%, +10%, +20% and +25%. The arithmetic average is identical for both (+3% a year), and so is the compounded average. The only difference is the order.

Ada has bad luck: her crash lands first. Ben has good luck: the same crash lands last. Each year the market return is applied, then the £25,000 withdrawal is taken.

After just five years, Ada and Ben are £75,760 apart despite earning the same average return and taking the same income. Ada took her withdrawals out of a pot that had already been savaged by the year-one crash, so she was selling a larger fraction of a smaller portfolio at exactly the wrong time. Ben spent his early years withdrawing from a pot that had grown, and only met the crash once he had already banked years of gains.

Stretch this over a real 30-year retirement and the effect compounds. The same average return can leave one retiree with a healthy surplus and push an identically-invested neighbour towards running out of money. That worst-case - the pot hitting zero while you still need income - is the risk of ruin, the same downside that drives sensible position sizing in fractional Kelly staking.

Withdrawing in a downturn does two things at once. It crystallises the loss - a paper fall becomes permanent the moment you sell units to raise cash - and it removes shares that would otherwise have participated in the recovery. A portfolio down 30% needs to gain about 43% just to get back to where it started, and if you are simultaneously drawing an income, you are handing away the very units that would have delivered that rebound.

This is why sequence risk is front-loaded. Research on retirement withdrawals consistently finds that the returns in roughly the first decade after you start drawing an income matter far more to whether the money lasts than the returns in the final decade. Survive the first ten years without a severe early crash and the danger fades sharply.

For someone still paying into a pension, sequence risk runs in reverse. An early crash is actually good news for an accumulator: your regular contributions buy more units while prices are low, and those cheap units compound as markets recover. The dangerous sequence for a saver is the mirror image - strong early gains followed by a crash right before you retire, when the pot is at its largest and a big percentage fall wipes out the most pounds.

The practical takeaway is that the decade either side of your retirement date - the last few years of saving and the first few of spending - is the danger zone. That is the window where the size of your pot and your exposure to a bad sequence are both at their peak. It is also where the gap between expected value and expected utility is widest: the maths might say stay fully invested for the highest average outcome, but the pain of a ruinous early crash is not symmetric with the joy of an extra few percent of upside.

The famous 4% rule - the idea that you can withdraw 4% of your starting pot, rise it with inflation each year, and rarely run out over 30 years - exists precisely because of sequence risk. William Bengen derived it in 1994 by testing withdrawal rates against the worst historical return sequences, not the average ones. The 4% figure is deliberately conservative because it has to survive a retiree who is unlucky enough to retire straight into a crash.

In the UK, pension freedoms let you take an income directly from an invested pot through flexi-access drawdown. That flexibility is powerful, but it puts sequence risk squarely on your shoulders: a bad first few years can permanently impair the pot. An annuity does the opposite - it hands the sequence risk (and longevity risk) to an insurer in exchange for a guaranteed income, at the cost of flexibility and any upside. Many retirees split the difference, securing essential spending with a guaranteed floor and leaving the rest invested. The government's retirement income guidance and the free Pension Wise service are the sensible starting points before making that call.

• The Trinity study on sustainable withdrawal rates - Wikipedia
• William Bengen and the origin of the 4% rule - Wikipedia
• Plan your retirement income - GOV.UK