Same Average Return, Different Outcomes
During the accumulation phase, the order of returns (the sequence of good and bad years) has almost no impact on the final asset value. However, during the withdrawal phase, the order of returns can dramatically affect how long your assets last. This is sequence of returns risk.
Consider withdrawing 150 man-yen annually from a 3,000 man-yen portfolio. In a scenario where the first 5 years are strong (+15% per year) and the last 5 years are weak (-5% per year), versus a scenario where the first 5 years are weak and the last 5 years are strong, the 10-year average return is the same +5% in both cases. However, the remaining balance differs dramatically: the former leaves approximately 3,200 man-yen, while the latter leaves only about 2,400 man-yen.
Why a Crash Right After Retirement Is Most Dangerous
When a crash occurs immediately after you begin withdrawals, your assets drop sharply and you continue withdrawing a fixed amount from a depleted portfolio, making recovery extremely difficult. If a 3,000 man-yen portfolio drops 30% in the first year to 2,100 man-yen, and you withdraw 150 man-yen, the remaining balance is 1,950 man-yen. Recovering to the original 3,000 man-yen requires approximately a 54% gain, which is extremely difficult to achieve while continuing withdrawals.
Conversely, if the first several years after retirement are strong, your assets grow sufficiently before encountering a later crash, limiting its impact. In other words, the returns during the first 5-10 years after retirement are what determine your portfolio's longevity.
30-Year Withdrawal Simulation
Let's compare withdrawing 120 man-yen annually (10 man-yen per month) from a 3,000 man-yen portfolio under three scenarios. Scenario A (strong then weak): first 15 years at +8% per year, last 15 years at +2% per year. Remaining balance after 30 years: approximately 2,850 man-yen. Scenario B (weak then strong): first 15 years at +2% per year, last 15 years at +8% per year. Remaining balance after 30 years: approximately 1,200 man-yen. Scenario C (steady): 30 years at a constant +5% per year. Remaining balance after 30 years: approximately 2,100 man-yen.
The average return is 5% per year in all three scenarios, yet the outcomes differ dramatically. The gap between Scenario A and B is approximately 1,650 man-yen. This gap is the essence of sequence of returns risk and the most critical risk to manage in post-retirement asset management. Books on post-retirement asset management clarify when and how to shift to a defensive investment approach.
Strategies to Mitigate Sequence of Returns Risk
The fundamental strategy is to reduce withdrawal amounts immediately after retirement. Adopting a percentage-based withdrawal (3-4% of assets) means that in years when assets decline, the withdrawal amount automatically decreases, reducing the risk of portfolio depletion. Additionally, holding 2-3 years of living expenses in cash at retirement means you can avoid selling investment assets during a crash.
Another effective strategy is gradually reducing your equity allocation before retirement. Lowering your equity allocation from 80% to 50% over the 5 years before retirement significantly cushions the impact of a crash. Target-date funds perform this adjustment automatically. Books on withdrawal strategies explain optimization techniques for withdrawal sequencing to extend portfolio longevity.
Next Steps - Plan Your Withdrawal Strategy
If retirement is approaching, plan your withdrawal strategy in concrete terms. (1) Hold 2-3 years of living expenses in cash at retirement, (2) Use percentage-based withdrawals (3.5-4% per year) as your baseline, (3) Establish a rule to temporarily reduce withdrawals during crashes. Implementing these three measures alone significantly mitigates sequence of returns risk.
Try our simulator with various withdrawal scenarios. By adjusting the withdrawal amount and assumed return rate, you can see how long your assets will last.