How to Protect Against Sequence of Returns Risk

In our previous posts, Real Income: Using Dividends and Interest to Avoid Running Out of Retirement Funds and The Fear of Relying on Yield for Income, we established that the most efficient and effective method of generating income from retirement assets is through dividends from stocks and interest from bonds.

In doing so, we briefly touched on one of the most significant threats to a retiree's financial security — sequence of returns risk. In this post, we will take a deeper look at what sequence of returns risk is, why it is so dangerous, and most importantly, how retirees can protect against it by using income from dividends and interest.

What Is Sequence of Returns Risk?

Sequence of returns risk is the risk that the timing of withdrawals from a retirement portfolio will negatively impact the overall rate of return available to the investor. In simpler terms, it is the risk of experiencing poor market returns early in retirement — precisely when you begin drawing down your assets for income.

Unlike investors who are still in the accumulation phase, retirees do not have the luxury of waiting out a bear market. They need income now. When a retiree is forced to sell assets during a market downturn to generate income, they are locking in losses and permanently reducing the number of shares available to recover when the market eventually rebounds. This creates a compounding problem that can be nearly impossible to recover from, even if the market subsequently delivers strong returns.

This is not a theoretical risk. It is a real and documented threat to the financial security of retirees, and it grows more relevant with each passing year as approximately 4 million Americans reach age 65 annually through 2030.

Why the Timing of Returns Matters

To understand why the sequence of returns matters so much in retirement, consider two retirees who each begin with $1 million in retirement savings and withdraw 4% annually, increasing by 3% each year for inflation. Both retirees experience the same average annual return over their retirement. The only difference is the order in which those returns occur.

As we illustrated in Real Income: Using Dividends and Interest to Avoid Running Out of Retirement Funds, a retiree who began retirement in 1999 — the last year of the bull market before the dot-com bubble burst — ended 25 years of retirement with an asset balance of $670,795. A retiree who began retirement just one year later, in 2000, ran out of money entirely by 2023, two years short of the same 25-year period.

Same market returns. Same withdrawal rate. Drastically different outcomes — determined entirely by when retirement began.

This is the essence of sequence of returns risk. And it is why any income strategy that depends on the market appreciating each year to fund withdrawals is fundamentally flawed for retirees.

The Methods Most Vulnerable to Sequence of Returns Risk

The two most common income generation methods used today — the 4% Rule and share liquidation — both suffer from the same underlying vulnerability. They require the portfolio to sell assets to generate income.

Under the 4% Rule, retirees withdraw 4% of their portfolio balance in the first year and adjust for inflation each subsequent year. The assumption embedded in this rule is that market returns will, on average, replenish what is withdrawn. But when a bear market strikes in the first several years of retirement, withdrawals accelerate the depletion of assets at exactly the wrong time — when prices are depressed and shares are worth less.

Share liquidation suffers from the same problem. When you sell shares to generate income, the price at which you sell matters enormously. Selling shares in a down market means selling more shares to generate the same dollar amount of income. Those shares are no longer available to participate in the eventual market recovery. This is why we refer to share liquidation as the most inefficient method of generating income — you are permanently reducing your ownership stake at the very moment it is most costly to do so.

The total return approach commonly used by financial advisors is also not immune. As noted in a Morningstar webinar on retirement spending strategies, the prevailing approach is to generate partial income from yield and supplement the remainder through portfolio liquidation, with the expectation that the portfolio will appreciate enough to compensate. However, this approach still introduces sequence of returns risk for the portion of income that must come from selling assets.

How Dividends and Interest Eliminate Sequence of Returns Risk

The fundamental reason that income from dividends and interest protects against sequence of returns risk is straightforward: you do not have to sell shares to generate income.

When a retiree holds dividend-paying stocks and interest-bearing bonds, the income is generated from the number of shares they own — not from the price of those shares. Whether the market is up 20% or down 30% in a given year, the dividends and interest deposited into the retiree's account are determined by the holdings and the yield — not by the price movement of the market.

This is a critical distinction. When income is generated from dividends and interest:

• The number of shares owned remains intact, regardless of market conditions

• The retiree is not forced to sell at depressed prices during a bear market

• The portfolio retains its full capacity to recover and grow when markets rebound

• The income stream is predictable and reliable, regardless of market direction

Dividends cannot be faked. They are paid in cash and deposited directly into the account. Interest from bonds is the same. This makes dividends and interest a real and tangible form of income — one that is not contingent on favorable market conditions or a positive sequence of returns.

A Side-by-Side Comparison: Share Liquidation vs. Dividends and Interest

To illustrate the difference in outcomes, consider a retiree who retires in 2000 — the beginning of a three-year bear market — with $1 million in retirement savings and a need for $40,000 in annual income, increasing by 3% each year for inflation.

Under the share liquidation method, as shown in Table 2 of our previous post, this retiree runs out of money in 2023 after 24 years. The three consecutive years of negative returns at the start of retirement — 2000, 2001, and 2002 — permanently impair the portfolio's ability to sustain withdrawals for the full retirement period.

Now consider the same retiree using a Target Income Portfolio designed to generate 4% in annual income entirely from dividends and interest, using the sample portfolio below.

Sample Target Income Portfolio

Fund	Asset Class	Percent of Portfolio	Amount	Yield	Annual Income
Income Fund of America	Equity Income Fund	30%	$300,000	3.8%	$11,400
Capital Income Builder	Global Equity Income	30%	$300,000	3.1%	$9,300
Bond Fund of America	Long Bond Fund	15%	$150,000	4.3%	$6,450
U.S. Government Securities Fund	Treasury Bond	5%	$50,000	4.1%	$2,050
American High Income Trust	High Yield Bond	15%	$150,000	6.4%	$9,600
Capital World Bond	Global Bond	5%	$50,000	3.1%	$1,550
	TOTAL	100%	$1,000,000	4.04%	$40,350

In this portfolio, the retiree's $40,350 in annual income is generated entirely from dividends and interest. In 2000, 2001, and 2002, when the S&P 500 declined by 9.1%, 11.89%, and 22.1% respectively, this retiree's income was not impacted. The dividends were still paid. The interest was still deposited. The retiree did not need to sell a single share.

As we demonstrated through backtesting in our previous post, the same portfolio generated a total income of $1,551,788 over 25 years beginning in 2000 and ended the period with a portfolio balance of $1,596,835 — compared to the share liquidation retiree who ran out of money two years before the period ended. This represents a difference of over $1.7 million in outcomes — driven entirely by the method of income generation.

The Role of Dividend Stability in Protecting Income

Not all dividends are created equal. One of the most important factors in building a portfolio designed to generate reliable income through dividends and interest is the quality and stability of the dividend-paying holdings.

Companies with a long history of paying and growing dividends tend to maintain their dividends even during market downturns. Johnson & Johnson, for example, has paid a rising dividend for more than 60 consecutive years, through multiple recessions, bear markets, and periods of economic uncertainty. As we noted in our previous post, JNJ has returned an average of 9% annually over the last 20 years, with an average dividend yield of 2.84% — meaning the capital appreciation above yield has been approximately 6.16%.

This dividend stability has two important implications for retirees. First, it means the income stream is reliable and predictable, even when markets are volatile.

Second, dividend-paying companies tend to be more financially stable and established, which results in lower stock price volatility compared to non-dividend-paying stocks. According to Perkins Coi Trust Company, dividend payers have up to 30-33% lower volatility than non-dividend-paying stocks. In a down market, this lower volatility means less downside capture — and less anxiety for the retiree.

What Happens to the Portfolio During a Bear Market?

When a retiree holds a dividend and interest-based income portfolio and a bear market occurs, three important things happen — and none of them require selling shares.

First, the income continues. Dividends and interest are paid based on the holdings, not the price. The income stream is unaffected by the market decline.

Second, the share count is preserved. Because there is no need to sell shares for income, the retiree maintains full ownership of their positions throughout the downturn.

Third, the portfolio is positioned for full recovery. When markets rebound — as they historically have — the retiree's unchanged share count participates in the full recovery, including any capital appreciation above the yield.

This is in direct contrast to the share liquidation retiree, who enters a bear market forced to sell at depressed prices, exits with a reduced share count, and recovers from a lower base — permanently impairing their long-term portfolio value.

Building a Portfolio That Protects Against Sequence of Returns Risk

Designing a portfolio that eliminates sequence of returns risk requires a fundamental shift in how income is defined and delivered. Instead of targeting a total return and extracting income through share liquidation, the portfolio should be designed from the outset to generate the investor's required income entirely from dividends and interest.

We refer to this as a Target Income Portfolio — a concept analogous to Target Date Funds in the accumulation phase, but designed specifically for the decumulation phase. Rather than specifying a target retirement date, a Target Income Portfolio specifies a target income yield, such as 2%, 3%, 4%, or 5%, matching the portfolio design directly to the retiree's income need.

The key steps in constructing a Target Income Portfolio are as follows.

First, determine the income need. If a retiree has $1 million in retirement assets and needs $40,000 per year in income, the target income yield is 4%. This becomes the design objective for the portfolio.

Second, select holdings that collectively achieve the target yield. As illustrated in the sample portfolio above, this can be accomplished using a mix of equity income funds, global income funds, bond funds, and high yield bonds. The yield of each holding, weighted by its allocation, should aggregate to the target yield of the overall portfolio.

Third, account for the relationship between yield and capital appreciation. As we discussed in The Fear of Relying on Yield for Income, there is an inverse relationship between yield and capital appreciation. Higher-yielding positions will generally have lower capital appreciation potential, and vice versa. A well-constructed Target Income Portfolio balances these two objectives — generating sufficient yield to meet the income need while maintaining capital appreciation potential to grow the portfolio over time and keep pace with inflation.

Fourth, maintain and rebalance the portfolio over time. As interest rates change, yields fluctuate, and market prices shift, the portfolio will need to be rebalanced and reallocated to maintain the target yield and overall investment objectives. This ongoing management is the real art and science of income portfolio construction.

The Long-Term Advantage: Preserving and Growing the Principal

One of the most compelling long-term advantages of using dividends and interest for income is the preservation — and potential growth — of the principal investment. Because the retiree is not selling shares to generate income, the number of shares owned remains intact over the entire retirement period. This has two significant long-term benefits.

The first is estate preservation. The retiree's heirs have the potential to inherit a portfolio that has maintained or grown its value over the retirement period — rather than a depleted account. The second is inflation protection. While the income generated from dividends and interest may not increase at the same rate as inflation every year, the capital appreciation potential of the equity holdings in the portfolio provides the opportunity for the portfolio's overall value to grow over time, helping to offset the long-term erosion of purchasing power.

As demonstrated in our backtesting example, the same $1 million invested in a Target Income Portfolio in 2000, generating 4% in income annually from dividends and interest, ended 25 years later with a portfolio balance of $1,596,835. Despite distributing over $1.5 million in income over 25 years, the original principal was not only preserved — it grew by nearly 60%.

This outcome would have been impossible under the share liquidation method, where the same retiree ran out of money entirely.

Conclusion

Sequence of returns risk is one of the most significant and underappreciated threats to retirement security. For retirees who rely on share liquidation or the 4% Rule to generate income, a bear market at the beginning of retirement can be financially devastating — and largely unrecoverable.

The solution is not to predict the market or time retirement to avoid a downturn — no one can do that reliably. The solution is to design a retirement income strategy that is not dependent on the market appreciating each year in order to generate income.

By using dividends and interest as the primary source of retirement income, retirees can protect against sequence of returns risk entirely. Their income does not require selling shares. Their principal is preserved. Their portfolio retains its full capacity to recover and grow. And they can face any market environment — bull or bear — with the confidence that their income will continue to be deposited into their account, regardless of what the market does.

This is the power of a Target Income Portfolio — and the reason we believe it is the most effective and reliable approach to retirement income planning.