After over 20 years in financial services and more than a decade as an independent agent, I’ve seen countless retirees face a challenge most people never heard of during their working years: sequence of returns risk. It’s one of the most overlooked threats to retirement security, and frankly, it’s something that keeps me up at night when I think about my clients’ futures.
The concept is simple, but the consequences are profound. Sequence of returns risk is the danger that experiencing poor investment returns early in retirement can permanently impair your ability to maintain income throughout your retirement years. Even if your investments eventually recover and deliver solid average returns over time, the timing of those returns can make or break your retirement plans.
What Makes Sequence of Returns Risk So Dangerous
Let me paint a picture that illustrates why timing matters so much in retirement. Imagine two retirees who both have $1 million saved and plan to withdraw $50,000 annually (a 5% withdrawal rate). Both experience identical market returns over 20 years - some good years, some bad years - but in different sequences.
Retiree A experiences strong returns in the first decade of retirement, followed by poor returns. Retiree B faces the exact opposite: poor returns early, strong returns later. Even though their average returns are identical, Retiree B - who faced the poor returns early - runs out of money years before Retiree A.
This happens because when you’re withdrawing money during down markets, you’re forced to sell more shares or liquidate more assets to maintain your income. Those assets are gone forever and can’t participate in any future recovery. It’s like taking money out of a bucket that has holes in the bottom - the bucket empties much faster than if it were just leaking without you also scooping water out.
During my years in financial services, I’ve watched too many retirees who had “adequate” nest eggs on paper struggle when market downturns hit early in their retirement. The 2008 financial crisis was particularly brutal for people who had just retired or were planning to retire soon.
The Traditional 4% Rule Falls Short
Most financial planning still relies heavily on the 4% rule - the idea that you can safely withdraw 4% of your retirement portfolio annually. This rule was developed based on historical market data, but it doesn’t account for sequence of returns risk in our current low-yield, high-volatility environment.
The 4% rule assumes you can ride out market volatility over time. But when you’re retired and need that money for living expenses, you don’t have the luxury of waiting decades for markets to recover. You need income every month, regardless of what the stock market did last quarter.
This is where I’ve seen the real value of incorporating annuities into retirement planning. While I’m not suggesting anyone put all their money into annuities, they serve a crucial role in creating a foundation of guaranteed income that isn’t subject to sequence of returns risk.
How Fixed Annuities Eliminate Sequence Risk
Fixed annuities provide a straightforward solution to sequence of returns risk: they eliminate it entirely for the portion of your retirement income they cover. When you purchase a fixed annuity, the insurance company guarantees specific payments for a set period or for life, regardless of market conditions.
The insurance company takes on the investment risk and the longevity risk. Your income payments remain stable whether the market goes up, down, or sideways. There’s no sequence risk because there’s no market exposure in the income calculation.
I’ve helped many clients use fixed annuities as the foundation of their retirement income strategy. They know their essential expenses - housing, utilities, healthcare, food - are covered by guaranteed payments. This allows them to be more aggressive with other portions of their portfolio because they’re not depending on those assets for basic living expenses.
Fixed annuities work particularly well for people who value predictability and peace of mind over maximum growth potential. The tradeoff is that you give up some upside potential in exchange for certainty.
Indexed Annuities: A Middle Ground Approach
For clients who want some protection against sequence of returns risk but also want participation in market growth, indexed annuities offer an interesting middle ground. These products link your returns to a market index (often the S&P 500) but provide a floor that protects against losses.
With an indexed annuity, you typically get a portion of the market’s upside when it performs well, but you don’t lose money when the market declines. This helps address sequence of returns risk because even if markets perform poorly early in your retirement, your account value doesn’t decline.
The protection comes with some limitations - you usually won’t get 100% of the market’s gains due to caps or participation rates. But for many retirees, that’s a reasonable tradeoff for the peace of mind that comes with principal protection.
I’ve found indexed annuities work well for people who are nervous about market volatility but don’t want to completely give up growth potential. They provide a way to participate in markets while removing the sequence risk that can be so damaging to retirement outcomes.
Creating a Layered Retirement Income Strategy
In my experience, the most effective approach to addressing sequence of returns risk involves creating layers of retirement income. Think of it like building a foundation for a house - you want the most reliable, stable components at the bottom, supporting everything else.
The first layer might be Social Security and any pension benefits - guaranteed income sources that aren’t subject to market risk. The second layer could include annuities that provide additional guaranteed income to cover essential expenses. The third layer might include more growth-oriented investments that can provide additional income and help maintain purchasing power over time.
This layered approach means that even if the growth-oriented portions of your portfolio face sequence risk, your basic needs are still covered by guaranteed income sources. You have more flexibility to weather market storms because you’re not forced to liquidate investments during down markets just to pay for groceries and utilities.
The key is right-sizing each layer based on your specific situation, risk tolerance, and income needs. There’s no one-size-fits-all solution, which is why working with someone who understands these products and strategies is so important.
The Insurance Company’s Role in Managing Risk
One question I often get is: “How can insurance companies guarantee payments when they’re investing in the same markets I would be?” It’s a great question that gets to the heart of how annuities work.
Insurance companies have several advantages in managing sequence of returns risk. First, they pool risk across thousands of customers, which allows them to smooth out the timing differences. While some customers might experience poor early returns, others experience good early returns, and these tend to balance out across a large pool.
Second, insurance companies invest with very long time horizons and maintain substantial reserves. They’re not forced to liquidate investments during down markets to meet current obligations. They can weather short-term volatility because they’re managing money across decades, not years.
Third, insurance companies use sophisticated actuarial science to price their guarantees, incorporating multiple scenarios including adverse market sequences. The guarantees are backed by the insurance company’s full assets and, in most cases, by state guaranty associations that provide additional protection.
- Sequence of returns risk occurs when poor market performance early in retirement permanently damages your ability to maintain income throughout retirement
- Traditional withdrawal strategies like the 4% rule don’t adequately address this timing risk
- Fixed annuities eliminate sequence risk entirely by providing guaranteed payments regardless of market conditions
- Indexed annuities offer a middle ground, providing principal protection while allowing for some market participation
- A layered retirement income strategy using guaranteed sources for essential expenses provides the most effective protection
- Insurance companies can provide guarantees because they pool risk, invest long-term, and maintain substantial reserves
- The key is right-sizing annuity allocations based on your specific income needs and risk tolerance
Sequence of returns risk is real, and it’s destroyed more retirement plans than most people realize. The good news is that it’s entirely manageable if you plan for it. Annuities aren’t the only solution, but they’re one of the most effective tools available for creating the guaranteed income foundation that can protect you from this risk.
If you’re concerned about sequence of returns risk and want to explore how annuities might fit into your retirement income strategy, I’d be happy to discuss your specific situation. Every person’s needs are different, and the right approach depends on your income requirements, risk tolerance, and overall financial picture. Contact Heritage Life Solutions today to learn more about protecting your retirement from market timing risk.
