Sequence-of-Returns Risk Explained: Why Average Returns Can Mislead Retirees

Written by Finnovate

Content Team

Two people retire with the same corpus. They withdraw the same amount every year and receive the same set of investment returns.

Yet one finishes with considerably more money.

The difference is not the average return. It is the order in which the good and bad returns arrive.

What Is Sequence-of-Returns Risk?

Sequence-of-returns risk, also called sequence risk, is the risk created by the timing of investment gains and losses while money is being withdrawn from a portfolio.

A market fall is uncomfortable for any investor. But it becomes more damaging when the investor must also sell investments to meet regular expenses.

This risk is most relevant to people who have:

• Recently retired
• Started a Systematic Withdrawal Plan, or SWP
• Stopped receiving a regular salary
• Started using investments to pay monthly expenses
• Reached the withdrawal stage of an important financial goal

A complete retirement planning strategy should therefore cover two connected stages: building the corpus and drawing income from it after retirement. Treating these stages as separate exercises can leave the withdrawal plan exposed to risks that were not visible during accumulation.

A Simple ₹1 Crore Sequence-of-Returns Example

Consider two retirees, Investor A and Investor B.

Both investors receive the same five annual returns. Investor A receives the positive returns first. Investor B receives the negative returns first.

The withdrawal is made at the end of each year.

This gap may become much larger over a longer retirement period, particularly when withdrawals rise with inflation.

Why Did the Two Investors Get Different Outcomes?

Investor B faced a 20% loss in the first year.

The ₹1 crore portfolio first fell to ₹80 lakh. After the ₹6 lakh withdrawal, only ₹74 lakh remained invested.

A second negative year followed. This reduced the corpus further, before the stronger returns had a chance to arrive.

When positive returns finally came, they were earned on a much smaller amount.

Investor A had the opposite experience. The early gains increased the portfolio before the negative years arrived. This gave the portfolio a larger base and a better ability to absorb the later losses.

Why Average Return Does Not Tell the Full Story

Retirement projections often assume that a portfolio will earn a steady return, such as 8% or 10% every year.

This is useful for making an estimate. But real investment returns do not arrive in a straight line.

A portfolio may earn:

• 18% in one year
• -12% in the next year
• 7% in the following year
• 22% after that

The long-term average may look reasonable. But the retirement outcome can still change depending on when the negative years occur.

This is why retirement planning should consider poor early returns, high inflation and longer life expectancy, instead of relying only on one average-return assumption.

Sequence Risk During SIP and SWP

The effect of market volatility changes when an investor moves from adding money to withdrawing money.

How a Falling NAV Affects an SWP

A Systematic Withdrawal Plan provides regular income by redeeming enough mutual fund units to meet the chosen withdrawal amount.

Suppose you need to withdraw ₹50,000 from a mutual fund.

You receive ₹50,000 in both cases. But at the lower NAV, 250 additional units are sold.

Those units will no longer benefit if the fund later recovers.

This does not mean every SWP is unsuitable. It means the withdrawal amount, asset allocation, time horizon and source of the withdrawal must be planned together. Our guide to common SWP mistakes and their practical fixes explains why an SWP should not be started using the payout amount alone.

You can use Finnovate's SWP Calculator with Inflation to understand how withdrawals and rising expenses may affect a corpus under an assumed rate of return. The result is an illustration, not a guaranteed outcome.

When Is Sequence-of-Returns Risk Highest?

Sequence risk is generally most important during the period close to retirement, particularly the final years before retirement and the early years after withdrawals begin.

The risk can be higher when:

• A major market fall occurs soon after retirement
• Withdrawals begin immediately
• The withdrawal amount is high compared with the corpus
• Most of the portfolio is held in volatile assets
• There is no separate reserve for near-term expenses
• Withdrawals rise quickly with inflation
• The retirement period may last 25 to 30 years or longer

There is no fixed year after which sequence risk disappears. Its effect depends on the remaining corpus, withdrawal rate, portfolio structure, inflation and other sources of income.

What Can Increase Sequence-of-Returns Risk?

1. A High Initial Withdrawal

A higher withdrawal leaves less money invested. If this happens during a falling market, the portfolio may shrink more quickly than expected.

2. Depending Entirely on Equity for Immediate Expenses

Equity can support long-term growth, but it can also fall sharply over shorter periods. Depending entirely on equity for immediate expenses may force an investor to sell during a correction.

3. No Emergency or Liquidity Reserve

Medical costs, family requirements or home repairs may lead to additional withdrawals. Unplanned withdrawals during a weak market can place further pressure on the portfolio.

4. Automatically Increasing Every Withdrawal

Retirement income must keep pace with inflation. But increasing withdrawals mechanically after a severe market fall may weaken an already reduced portfolio.

5. A Plan With No Margin for Error

A projection may work when returns, inflation and expenses behave exactly as assumed. Real retirement rarely follows one fixed path.

How to Reduce Sequence-of-Returns Risk

Future market returns cannot be predicted. The aim is therefore not to avoid every fall. It is to reduce the chance that a temporary fall creates permanent damage.

1. Keep Near-Term Expenses Away From Volatile Assets

Money required for regular expenses in the near future should not depend entirely on short-term equity-market performance.

A separate cash or low-volatility reserve can help regular withdrawals continue during a weak market without immediately selling long-term growth assets. The amount should be based on expenses, regular income, portfolio size and the investor's ability to adjust spending.

2. Use a Retirement Bucket Strategy

A bucket strategy divides retirement assets according to when the money may be required.

The objective is not to create three unrelated portfolios. It is to avoid selling long-term investments each time a monthly expense arises.

Our detailed guide to the bucket retirement strategy in India explains how cash, income and growth buckets can work together during retirement.

3. Keep Withdrawals Flexible

Not all retirement expenses are equally urgent.

Essential expenses may include food, housing, medical costs, insurance and utilities. Discretionary expenses may include expensive holidays, major gifts, luxury purchases or non-urgent renovations.

During a severe market fall, reducing or delaying discretionary withdrawals can lower pressure on the portfolio.

4. Maintain an Appropriate Asset Allocation

Moving the entire retirement corpus into low-growth investments can create another problem. Retirement may last for several decades, and inflation can steadily reduce purchasing power.

The portfolio may therefore need both stable assets for near-term requirements and growth assets for long-term expenses.

The suitable mix depends on the retiree's income sources, required withdrawals, age, health, liabilities, dependants, time horizon and risk capacity. Read our guide to asset allocation in India for a broader explanation of how equity, debt and other asset classes play different roles.

5. Rebalance the Portfolio Periodically

Suppose strong equity returns increase the equity portion of the portfolio beyond the planned level.

Rebalancing may involve moving part of those gains towards the short-term or fixed-income bucket. This can help refill the spending reserve during stronger market periods.

Rebalancing should follow a planned allocation rather than a prediction about where markets may move next.

6. Separate Regular Income From Portfolio Income

Some retirees receive income from pensions, annuities, rent, interest, consulting or a family business.

These sources may cover part of the essential expenses. The investment portfolio then needs to fund only the remaining gap, reducing the pressure created by regular redemptions.

However, each income source carries its own risks, including inflation, vacancy, credit risk, liquidity and taxation.

7. Review the Plan Before Retirement Begins

Sequence risk should ideally be considered before the first withdrawal.

A pre-retirement financial audit can help examine expenses, healthcare requirements, existing income, liquidity, asset allocation, taxation and estate arrangements before regular portfolio withdrawals begin.

Questions a Retirement Plan Should Answer

• How much will be withdrawn during the first year?
• How will the withdrawal change with inflation?
• Which assets will fund near-term expenses?
• What will happen if equity markets fall by 20%?
• Which expenses can be reduced temporarily?
• How will the spending reserve be refilled?
• How often will the portfolio be reviewed and rebalanced?
• What happens if retirement lasts longer than expected?

A retirement corpus is only one part of the plan. The system used to withdraw from that corpus is equally important.

Does the 4% Rule Protect Against Sequence Risk?

The 4% rule is a retirement-planning guideline that is often discussed online.

In its basic form, it suggests withdrawing 4% of the initial retirement corpus during the first year and increasing that rupee amount with inflation in later years.

But it is not a guaranteed or universal withdrawal rate.

Its suitability can change based on:

• Retirement duration
• Portfolio allocation
• Inflation
• Taxes and investment costs
• Market valuations at retirement
• Flexibility of spending
• Pension and other income sources
• The country and market data used for the analysis

A fixed withdrawal percentage does not automatically remove sequence risk. Poor early returns can still place pressure on the portfolio.

For an Indian retiree, the withdrawal rate should be based on actual expenses, expected inflation, taxation, asset allocation, income sources and the likely retirement period.

Can Dividends or Interest Remove Sequence Risk?

Dividend and interest income may reduce the need to sell investments. But they do not remove sequence risk completely.

Dividends are not guaranteed and may change. Dividend-paying investments can also lose market value.

Interest income may not always keep pace with inflation. Fixed-income investments can also carry credit risk, reinvestment risk, liquidity risk and interest-rate risk.

The useful question is not simply whether an investment produces regular income.

Can Sequence-of-Returns Risk Be Eliminated?

No strategy can guarantee that markets will not fall soon after retirement.

Sequence risk cannot be completely eliminated because future returns and their order are unknown.

Its impact can, however, be reduced through:

• A reasonable withdrawal rate
• A suitable equity and debt allocation
• Separate liquidity for near-term expenses
• Flexible discretionary spending
• Periodic rebalancing
• Multiple sources of retirement income
• Regular retirement-plan reviews

The aim is not to predict the next market fall. It is to avoid being forced into damaging decisions when the fall occurs.

Conclusion: Retirement Planning Is More Than Reaching a Corpus

Two retirees can start with the same amount, receive the same set of returns and withdraw the same amount, yet experience very different results.

The difference may simply be the order in which market returns arrive.

This is why retirement planning should not rely only on an average return or a target corpus. It should also define how near-term expenses will be funded, how withdrawals will respond to weak markets and how the portfolio will be rebalanced over time.

In retirement, earning a good long-term return matters. But having a plan for the difficult early years may matter just as much.

FAQs

Disclaimer: This article is for educational purposes only and does not constitute investment, tax or legal advice. Investment returns are market-linked and cannot be guaranteed. Retirement and withdrawal strategies should be selected based on individual goals, expenses, risk capacity, time horizon, taxation and other sources of income. Please consult a SEBI-registered investment adviser before making any investment decision.