Sequence of Returns Risk: Why the First Years Matter Most

Most people planning retirement focus on the average return they might earn. Sequence of returns risk is the reminder that the average is not the whole story once you begin drawing income. The order in which good and bad years arrive can make the difference between a portfolio that lasts comfortably and one that runs short, even when the long-run average is identical.

This article is for pre-retirees and new retirees in Ottawa and across Ontario who are moving from saving to spending, and for anyone who wants to understand why the first years of retirement carry outsized weight. The concept is not complicated, but its implications shape how a sound income plan is built.

Why the order of returns suddenly matters

While you are saving and contributing, the sequence of returns barely matters. A bad year early simply means you buy at lower prices, and over decades the order washes out. What counts is the average.

Everything changes when you start withdrawing. Now you are selling assets each year to fund spending. If a market decline hits early, you are selling more units at depressed prices to raise the same dollars, which permanently reduces the base left to recover. A strong rebound later helps a smaller pool. This is why two retirees who experience the exact same set of annual returns, in reverse order, can end up in very different places.

The risk, in short, is created by the combination of withdrawals and falling markets happening at the same time.

A simple illustration

Consider two hypothetical retirees who both start with the same portfolio, withdraw the same amount each year, and earn the same average return over a long period. The only difference is the order of returns: one experiences weak markets first, the other strong markets first.

Scenario	Early years	Later years	Long-term effect
Weak-first	Poor returns while withdrawing	Strong returns on a reduced base	Portfolio depletes faster
Strong-first	Good returns while withdrawing	Poor returns on a larger base	Portfolio lasts longer

This is an illustrative example only; actual results depend on markets, spending, and timing, and no particular outcome is guaranteed. The point is not the specific numbers but the direction: the weak-first retiree can run short even though the average return is the same. The order did the damage.

Why it is concentrated early

Sequence risk is sharpest in roughly the first five to ten years of retirement for two reasons. Your portfolio is at its largest, so a percentage decline removes the most dollars. And you have the longest remaining withdrawal period, so a permanently smaller base compounds its shortfall over many years.

Later in retirement the same percentage drop matters far less. The remaining horizon is shorter, and the portfolio has usually already weathered its most dangerous phase. This is why the transition into retirement deserves its own careful strategy rather than a simple continuation of your accumulation approach. The long horizons involved are also why inflation and retirement and sequence risk are often considered together.

Managing the risk

You cannot control markets, but you can control how exposed your income is to them in the vulnerable early years. Three levers do most of the work.

The first is a cash or short-term buffer. Holding a few years of spending in cash, GICs, or short-term instruments means a market decline does not force you to sell growth assets at a low point. You spend the buffer and give the portfolio time to recover. Our comparison of GICs, bonds, and high-interest savings covers the tools often used for this layer.

The second is flexible spending. A retiree who can trim discretionary spending in a bad year, deferring a major trip or a vehicle purchase, reduces how much must be sold at depressed prices. Even modest flexibility materially improves how long a portfolio lasts.

The third is the asset mix itself. A portfolio aligned with the withdrawal plan, rather than one that is either too aggressive or needlessly conservative, balances the need for stability early against the need for growth over a long retirement. This is the heart of our investment management work, and it connects to broader ideas in how to generate retirement income.

How it relates to the 4% rule

The well-known 4% guideline for withdrawals exists partly because of sequence risk. The rule was designed to survive poor early markets by setting a starting withdrawal rate conservative enough to weather a bad sequence. Its limitations, and how it applies to Canadian retirees specifically, are covered in the 4% rule in Canada.

The key insight is that a sustainable withdrawal rate is not simply the expected average return. It is lower, precisely to leave room for the possibility that your personal sequence of returns is an unfavourable one.

Practical steps as you approach retirement

As you move from saving to spending, a few deliberate actions reduce your exposure:

• Build a cash buffer covering two to three years of spending before you retire.
• Decide in advance how you would adjust spending in a weak market year.
• Review your asset mix so it suits a withdrawal phase, not an accumulation phase.
• Avoid locking in a rigid, inflation-indexed withdrawal that cannot flex downward.
• Revisit the plan annually, especially in the early years.

How you react to volatility also matters. Our note on market volatility and what to do addresses the behavioural side, which is often as important as the mechanics.

The bucket approach to income

One practical way retirees structure a portfolio around sequence risk is the bucket approach. The idea is to divide savings into layers matched to when the money will be spent. A short-term bucket holds cash and near-cash to fund the next few years regardless of markets. A medium-term bucket holds more conservative investments. A long-term bucket holds growth assets that have years to recover before they are needed.

The appeal is psychological as much as mathematical. When markets fall, you spend from the short-term bucket and leave the growth assets untouched, giving them time to recover rather than being forced to sell. In calmer periods you refill the near-term buckets from the growth layer. The approach does not change the underlying investments so much as it organises them around your spending timeline, which makes it easier to stay disciplined. It is a close cousin of the broader strategies in how to generate retirement income.

It cuts both ways

It is worth remembering that sequence risk is not purely a danger; it is a matter of luck in both directions. A retiree who happens to begin during a strong market stretch can find their plan more comfortable than projected. The problem is that you cannot know in advance which sequence you will get, and you only retire once. Because a bad early sequence is so much harder to recover from than a good one is to enjoy, sound planning is deliberately asymmetric: it prepares for the unfavourable case while letting the favourable case take care of itself. This is the same conservative logic that shapes sustainable withdrawal rates and is why planning for the downside, rather than the average, is the prudent default.

Next step

Sequence of returns risk is one of the clearest reasons that retirement income planning differs from saving for retirement. The same portfolio and the same average return can produce very different outcomes depending on when the weak years arrive, and the early years carry the most weight.

If you are approaching retirement in Ottawa or Ontario and want your income plan tested against a difficult sequence of markets, book a private consultation. You may also find the 4% rule in Canada a useful next read.