Sequence of Returns Risk: Why Your First 5 Years Matter Most

Imagine Sarah and James both retire at 65 with $800,000 in their KiwiSaver and other retirement savings. Both withdraw $50,000 annually. Over 20 years, both portfolios average 7% returns. Sarah's money lasts until she's 89. James runs out at 74.

What happened? Sarah experienced strong returns in her first five years of retirement. James hit a market downturn right as he started withdrawing. This is sequence of returns risk, and it's the most underappreciated danger facing New Zealand retirees today.

Sequence of returns risk is simple in concept but devastating in impact. It's the risk that you'll experience poor investment returns early in retirement, right when you're starting to make regular withdrawals from your savings.

During your working years, when you're contributing to KiwiSaver, market volatility actually works in your favor. A market crash? Great, you're buying more units at lower prices. But the moment you flip from accumulation to drawdown, everything changes.

When you're withdrawing money, you're forced to sell investments to fund your lifestyle. If markets drop 20% and you withdraw $50,000, you're selling far more units than you would have at higher prices. Those units are gone forever. They can't participate in the eventual recovery. This is called 'selling at a loss' or 'locking in losses', and it permanently reduces your portfolio's ability to sustain you.

The cruel mathematics: early losses + ongoing withdrawals = portfolio death spiral.

Let's make this concrete with two Kiwi retirees, both starting with $750,000 at age 65, both withdrawing $45,000 per year (6% initial withdrawal rate), both invested in a balanced portfolio.

Scenario A: Lucky Lucy
Lucy retires in 2009, right after the Global Financial Crisis. Markets recover strongly through her first five years: +25%, +15%, +12%, +18%, +10%. Even though she hits volatility later, her portfolio has grown enough to absorb it. Her money lasts until age 88 (23 years).

Scenario B: Unlucky David
David retires in 2007, right before the GFC. His first five years: -5%, -25%, +8%, +15%, +12%. Same average return over time, but the order is reversed. David's portfolio is depleted by age 79 (14 years).

Same returns. Same withdrawals. Nine fewer years of financial security. That's sequence risk.

The difference isn't academic. If you're relying on your savings to supplement NZ Super (which provides around $27,000-$42,000 annually for couples as of 2024, according to Work and Income NZ), running out nine years earlier could mean the difference between comfortable retirement and genuine hardship.

You might wonder: why specifically the first five years? Why not year 10 or year 15?

Three mathematical realities make early retirement the highest-risk period:

1. Your balance is at its peak
You've never had more money invested than on day one of retirement. A 20% loss on $800,000 is $160,000. The same percentage loss 15 years later, when your balance might be $450,000, is only $90,000. Larger balances mean larger absolute losses.

2. You're taking the highest dollar withdrawals
If you're withdrawing a fixed amount (say, $50,000 per year), those early withdrawals represent a larger percentage of a declining portfolio. In year one, $50,000 might be 6% of your balance. After a bad year, it might be 8% or 9%, accelerating depletion.

3. Lost compounding time
Money withdrawn (or lost) in year one can't compound for the next 20-30 years. Money lost in year 15 only loses 10-15 years of potential growth. Early losses have the longest 'shadow' across your retirement.

Think of your retirement portfolio like a mature tree. Damage to the trunk in the early years affects every branch that would have grown from it. Damage to an outer branch later has limited impact.

Knowing about sequence risk is unsettling. But you're not helpless. Here are five strategies Kiwi retirees commonly use to reduce this vulnerability:

1. Build a cash buffer (the 'sleep well' fund)
Hold 2-3 years of living expenses in cash or term deposits before you retire. If markets crash in your first year, you can draw from cash instead of selling investments at a loss. This gives your portfolio time to recover without forcing you to lock in losses.

For a couple needing $60,000 per year beyond NZ Super, that's $120,000-$180,000 in defensive assets. Yes, cash earns less than shares, but think of it as insurance, not investment.

2. Use a bucket strategy
Divide your portfolio into three buckets: cash (years 1-3), conservative investments like bonds (years 4-10), and growth assets like shares (year 11+). You only withdraw from bucket one. When markets are up, you refill bucket one from bucket two. When markets are down, you leave buckets two and three alone to recover.

This isn't a formal financial product; it's a mental framework that many advisers help clients implement within their existing KiwiSaver and investment accounts.

3. Stay flexible with withdrawals
Instead of withdrawing a fixed dollar amount every year, consider withdrawing a percentage of your portfolio (say, 4-5%). In good years, you get more. In bad years, you tighten the belt temporarily. This prevents you from selling excessive units during downturns.

The trade-off: less predictable income. Some retirees find this stressful. Others appreciate the discipline it creates. There's no universally correct answer, but the flexibility can extend portfolio longevity by years.

4. Consider a staged retirement
Instead of stopping work completely at 65, consider part-time work for the first 3-5 years. Even earning $15,000-$20,000 annually means withdrawing that much less from your portfolio during the danger zone. If markets recover while you're earning supplemental income, you've successfully navigated the highest-risk period.

Bonus: many Kiwis report that staged retirement feels less jarring psychologically than a hard stop.

5. Delay drawing down as long as possible
If you can live on NZ Super alone initially (perhaps you've paid off your mortgage and downsized), every year you delay touching your portfolio is a year of potential growth without withdrawals. Someone who retires at 65 but doesn't start drawing from savings until 68 has a dramatically lower sequence risk profile.

This also applies to KiwiSaver. You can access your KiwiSaver from age 65, but you don't have to withdraw it immediately. Leaving it invested while living on other income can be powerful.

Misconception 1: 'Average returns are what matter'
This is the most dangerous myth. In accumulation, average returns do largely determine outcomes. In drawdown, the order of returns matters more than the average. You can't eat an average.

Misconception 2: 'I'll just wait out the downturn'
If you're 45 and markets crash, sure, wait it out. If you're 68 and need to pay rates, insurance, and groceries, you can't just 'wait.' You're making withdrawals whether markets cooperate or not. That's the whole problem.

Misconception 3: 'Conservative funds eliminate sequence risk'
Conservative or defensive funds reduce volatility, which can help, but they also typically deliver lower long-term returns. If your conservative fund averages 4% and you're withdrawing 5%, you're depleting capital every year regardless of sequence. The risk shifts from sequence to longevity (outliving your money). It's a trade-off, not a solution.

Misconception 4: 'This only affects people with large balances'
Sequence risk affects anyone drawing down savings. Someone with $300,000 is actually more vulnerable than someone with $1 million because they have less buffer to absorb losses. Smaller balances mean percentage withdrawals are higher, and there's less room for error.

If you're reading this in year two or three of retirement and markets have been rough, you're not doomed, but you do need to respond.

Immediate actions to consider discussing with a financial adviser:

• Reduce withdrawals temporarily - Even cutting 10-15% for two years can make a significant difference to long-term sustainability
• Pause inflation adjustments - If you've been increasing withdrawals with inflation, freeze them at current levels until markets recover
• Return to work part-time - Earning even $10,000-$15,000 annually reduces portfolio stress substantially
• Review your investment mix - This isn't about timing the market; it's about ensuring your allocation still matches your risk tolerance and time horizon (a conversation for a licensed adviser)
• Delay large discretionary expenses - That new car or kitchen renovation? Postponing it by 2-3 years could save your portfolio

The key insight: sequence risk is highest in years 1-5, but if you've hit turbulence, years 3-8 become your new danger zone. The portfolio is wounded; you need to let it heal.

New Zealanders have a significant advantage over retirees in many countries: NZ Super provides a guaranteed income floor, adjusted for inflation, from age 65. As of 2024, this provides around $27,664 annually for single people living alone, and $42,380 for couples (combined), according to Work and Income NZ.

This dramatically reduces sequence risk for most Kiwis. If you can cover basic living expenses with NZ Super, your portfolio withdrawals become supplemental rather than essential. This means:

• You can reduce or pause withdrawals during market downturns
• Your withdrawal rate (as a percentage of portfolio) can be more conservative
• You have more flexibility to implement a bucket strategy or maintain cash reserves

Someone requiring $70,000 annually in retirement only needs $30,000-$42,000 from savings once NZ Super is factored in. That lower withdrawal rate creates much more resilience against sequence risk.

Of course, NZ Super alone may not fund the retirement lifestyle you're planning for. But it's a powerful buffer that shouldn't be overlooked in your retirement planning calculations.

The good news: sequence risk doesn't last forever. Research generally suggests that by year 10-15 of retirement, sequence risk diminishes significantly. Why?

By then, you've either successfully navigated the danger zone (your portfolio has grown or remained stable despite withdrawals), or you haven't (in which case the damage is done). Additionally, your remaining time horizon is shorter, so you're naturally holding more conservative investments with less volatility.

Think of it like launching a rocket. The first few minutes require the most fuel and face the highest risk of catastrophic failure. Once you're in orbit, you can relax slightly. Retirement follows similar physics.

This is why some advisers focus intensely on the 'retirement red zone', the period from five years before retirement to ten years after. It's your highest-risk window, and it deserves your most careful planning and monitoring.

This article is general information only and does not constitute personalised financial advice. For advice tailored to your situation, speak with a licensed Financial Advice Provider. You can find a registered adviser at fma.govt.nz.