Understanding Sequence of Returns Risk in Pension Drawdown

One of the most significant financial concepts for anyone entering pension drawdown is sequence of returns risk. This refers to the danger that poor investment returns early in retirement can have a lasting negative impact on your pension pot, even if later returns are strong.

This guide explains what sequence of returns risk means, why it matters specifically for drawdown, and how people typically think about managing this risk. If you're new to drawdown, you may want to read our how pension drawdown works guide first.

What Is Sequence of Returns Risk?

Sequence of returns risk, sometimes called sequencing risk, describes how the order in which investment returns occur affects your overall wealth, particularly when you are making withdrawals.

During the accumulation phase (while saving for retirement), the order of returns matters less. Whether you have good years first or last, the final pot value will be the same if the average return is the same.

However, once you begin withdrawing money, the sequence becomes critically important. Poor returns early in retirement, combined with withdrawals, can deplete your pot faster than expected, leaving less capital to benefit from any recovery.

A Simple Example

Consider two hypothetical scenarios with the same average return but different sequences:

Scenario A: Poor Returns Early

Year 1: -15%
Year 2: -5%
Year 3: +10%
Year 4: +15%
Year 5: +20%

Scenario B: Good Returns Early

Year 1: +20%
Year 2: +15%
Year 3: +10%
Year 4: -5%
Year 5: -15%

Both scenarios have the same average return. However, if you were withdrawing £15,000 annually from a £300,000 pot:

• Scenario A: After 5 years, you might have significantly less remaining
• Scenario B: The early growth provides a buffer, leaving more in your pot

This illustrates why the sequence - not just the average - matters when taking income.

Why Drawdown Is Particularly Vulnerable

Sequence risk is especially relevant for pension drawdown because:

1. Regular Withdrawals Are Being Made

When you take income from your pension, you are selling investments. If markets are down, you sell more units to achieve the same income. Those units cannot benefit from any subsequent recovery.

2. The Early Years Are Critical

The first 5-10 years of retirement are often called the "fragile decade." A significant market downturn during this period can permanently impair your retirement income potential.

3. You Cannot Recover Lost Time

Unlike during your working years, you typically cannot replace depleted pension funds with new contributions. Once capital is withdrawn during a downturn, it is gone.

4. Longevity Amplifies the Risk

A retirement lasting 25-30 years or more provides many opportunities for market volatility. The longer your retirement, the more important it becomes to manage early sequence risk.

The Mathematics Behind the Risk

To understand why sequence matters, consider the concept of pound-cost ravaging - the opposite of pound-cost averaging.

When saving, pound-cost averaging works in your favour: regular investments buy more units when prices are low and fewer when prices are high, averaging out your cost.

In drawdown, this process reverses. Taking regular income means selling more units when prices are low, accelerating the depletion of your pot during downturns.

Historical Context: Real-World Examples

Several periods in market history illustrate sequence risk:

The 2000-2002 Dot-Com Crash

Someone retiring in January 2000 would have experienced three consecutive years of falling markets. Combined with withdrawals, this could have severely impacted long-term sustainability.

The 2008 Financial Crisis

Markets fell approximately 40% from peak to trough. Retirees who had recently entered drawdown faced difficult decisions about maintaining their income.

The 2020 COVID Crash

While markets recovered quickly, those who sold investments during the March 2020 panic locked in losses that could not benefit from the subsequent recovery.

These examples demonstrate that sequence risk is not theoretical - it has affected real retirees throughout history.

Factors That Influence Sequence Risk Severity

Several factors affect how vulnerable a drawdown strategy is to sequence risk:

Withdrawal Rate

Higher withdrawal rates increase vulnerability. A 4% withdrawal rate provides more buffer than a 6% rate during market downturns. Use our pension drawdown calculator to model different withdrawal scenarios.

Asset Allocation

Portfolios heavily weighted towards equities have higher potential returns but also greater volatility, increasing sequence risk exposure.

Retirement Length

Longer retirements require the portfolio to last longer, giving sequence risk more opportunity to manifest.

Flexibility

The ability to reduce spending during downturns can help mitigate sequence risk's impact.

Approaches People Consider for Managing Sequence Risk

While there is no way to eliminate market uncertainty, various approaches are commonly discussed for managing sequence risk:

1. Cash Buffer Strategy

Maintaining one to three years of income needs in cash or near-cash investments allows continued income payments without selling growth assets during market downturns.

2. Bucket Strategy

Dividing investments into "buckets" based on time horizon:

• Short-term bucket: Cash and bonds for immediate income needs (1-3 years)
• Medium-term bucket: Balanced investments for 3-7 year needs
• Long-term bucket: Growth-oriented investments for 7+ year horizon

This structure provides time for growth investments to recover from downturns.

3. Flexible Withdrawal Strategy

Rather than fixed withdrawals, adjusting income based on portfolio performance. In poor years, taking less; in good years, potentially taking more.

4. Guardrails Approach

Setting upper and lower limits on withdrawal rates. If the portfolio falls significantly, withdrawals are reduced; if it grows substantially, withdrawals may increase.

5. Annuity Flooring

Using part of the pension to purchase an annuity covering essential expenses, while keeping the remainder in drawdown for flexibility. The annuity provides guaranteed income regardless of market conditions.

6. Phased Retirement

Continuing part-time work in early retirement reduces reliance on portfolio withdrawals during the vulnerable early years.

7. Conservative Allocation Initially

Starting retirement with a more conservative asset allocation, then potentially increasing equity exposure later once the initial sequence risk period has passed.

The Role of Asset Allocation

Asset allocation choices significantly impact sequence risk exposure:

Higher Equity Allocations

• Greater growth potential
• Higher volatility
• More vulnerable to sequence risk
• May be suitable for those with flexibility or other income sources

More Conservative Allocations

• Lower growth potential
• Reduced volatility
• Less sequence risk exposure
• May struggle to maintain purchasing power over long retirements

Many people consider a balance that provides some growth potential while managing volatility during the critical early retirement years.

Sequence Risk vs Longevity Risk

There is an inherent tension between sequence risk and longevity risk (the risk of outliving your money):

• Very conservative portfolios reduce sequence risk but may not grow enough to last a long retirement
• Growth-oriented portfolios may better support longevity but increase sequence risk

This tension is why many consider a balanced approach that evolves over time, potentially starting more conservatively and adjusting as the retirement progresses.

Warning Signs During Retirement

Once in drawdown, certain signals may indicate increased sequence risk concern:

• Portfolio value has fallen 20% or more from its peak
• Withdrawals are consuming more than 5-6% of the current portfolio value
• You are consistently withdrawing more than investment returns
• Cash reserves are depleted or minimal

Monitoring these factors can help identify when adjustments might be worth considering.

Planning Considerations

When thinking about sequence risk, many people find it helpful to consider:

• How flexible can income be in the early years?
• Are there other income sources (state pension, other pensions, part-time work)?
• What are essential vs discretionary expenses?
• How would a 30-40% market fall affect retirement plans?
• Is there capacity for some guaranteed income alongside drawdown?

These considerations can help frame conversations with financial advisers about appropriate strategies.

Summary

Sequence of returns risk is a crucial concept for anyone using pension drawdown. Unlike during the saving years, the order of investment returns matters significantly when making withdrawals. Poor returns early in retirement can have lasting effects that strong later performance may not fully overcome.

Understanding this risk and the various approaches people consider for managing it can help inform retirement planning decisions. However, the right strategy depends on individual circumstances, including income needs, other assets, flexibility, and risk tolerance.

Choosing the right drawdown provider can also impact your retirement outcomes. Compare pension drawdown providers or review fees and charges to understand the cost implications.

Speak to a qualified financial adviser for personal guidance on managing sequence of returns risk within your specific retirement plan.

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