What Is Sequence of Returns Risk?
Sequence of returns risk is the danger that the order in which an investor experiences investment returns—particularly poor returns early in a withdrawal period—can significantly impact the longevity of their retirement savings. This risk belongs to the broader category of retirement planning and risk management, as it directly threatens a retiree's ability to maintain their desired lifestyle and spending over time. Unlike simply the average rate of return, the sequence of those returns, especially during the crucial initial years of financial independence, can critically deplete a portfolio from which regular withdrawals are being made.
History and Origin
While the concept of how the timing of returns impacts portfolio sustainability has long been understood by financial professionals, Sequence of Returns Risk gained widespread attention with the rise of modern retirement planning and studies on sustainable withdrawal rates. Early research, such as the widely discussed "Trinity Study" from the late 1990s, highlighted that the order of returns matters significantly for portfolio longevity, especially when withdrawals are occurring. This research laid the groundwork for understanding that a series of market downturns at the beginning of retirement can have a disproportionately negative effect compared to the same downturns occurring later in retirement. Financial planning models increasingly incorporated this understanding to provide more robust guidance for retirees, emphasizing the importance of initial market performance. A detailed exploration of this risk highlights its critical role in portfolio sustainability for those in distribution phases. https://www.kitces.com/blog/understanding-sequence-of-returns-risk/
Key Takeaways
- Sequence of Returns Risk emphasizes that the timing of investment returns, not just the average return, is crucial, particularly during the early stages of retirement withdrawals.
- Poor returns at the beginning of retirement can deplete a portfolio faster, making it difficult to recover even with later positive returns.
- This risk is most pronounced when actively withdrawing income from a portfolio.
- Mitigation strategies often involve adjusting asset allocation, modifying withdrawal strategies, or maintaining cash reserves.
- Understanding and planning for Sequence of Returns Risk is a cornerstone of robust financial planning for retirees.
Formula and Calculation
Sequence of Returns Risk is not quantified by a single, explicit formula. Instead, its impact is observed through simulations and historical analysis that illustrate how different orders of returns affect a portfolio's longevity. There isn't a direct algebraic calculation for the "risk" itself, but rather a demonstration of its effect on a portfolio's terminal value given a specific withdrawal rate.
The calculation typically involves projecting portfolio values under various historical or hypothetical return sequences, applying a constant withdrawal amount (often adjusted for inflation).
Consider a simplified portfolio value (P_t) at time (t), with an initial value (P_0), an annual return (R_t) for year (t), and an annual withdrawal (W).
The portfolio value at the end of each year can be represented as:
Where:
- (P_t) = Portfolio value at the end of year (t)
- (P_{t-1}) = Portfolio value at the end of the previous year ((t-1))
- (R_t) = Annual rate of return for year (t)
- (W) = Annual withdrawal amount
To demonstrate Sequence of Returns Risk, one would compare two scenarios with the same average returns but different chronological orderings of positive and negative returns. This highlights how early negative returns can significantly reduce the base upon which future returns can compound.
Interpreting the Sequence of Returns Risk
Interpreting Sequence of Returns Risk involves understanding that the timing of positive and negative investment returns profoundly impacts a retirement portfolio. If a bear market or period of low returns occurs early in retirement, when withdrawals represent a larger percentage of the remaining portfolio value, the investor is selling assets at depressed prices. This early depletion can make it challenging for the portfolio to recover, even if strong returns follow later. Conversely, if early returns are strong, the portfolio grows, providing a larger base for future withdrawals and making it more resilient to subsequent market downturns. The risk is less about the magnitude of overall returns and more about when those returns occur relative to withdrawal periods. Consequently, strategies to mitigate Sequence of Returns Risk often involve a more conservative equity allocation in the initial years of retirement or dynamic spending rules.
Hypothetical Example
Consider two retirees, Alice and Bob, both starting retirement with a $1,000,000 portfolio and aiming to withdraw $40,000 annually (4% of the initial portfolio). Over five years, both portfolios experience the same average annual return of 5%, but the sequence of those returns differs.
Alice's Returns (Negative Returns Early):
- Year 1: -10%
- Year 2: -5%
- Year 3: +15%
- Year 4: +10%
- Year 5: +5%
Bob's Returns (Positive Returns Early):
- Year 1: +5%
- Year 2: +10%
- Year 3: +15%
- Year 4: -5%
- Year 5: -10%
Let's track their portfolio values:
Alice's Portfolio:
- Start: $1,000,000
- End Year 1: ($1,000,000 * 0.90) - $40,000 = $860,000
- End Year 2: ($860,000 * 0.95) - $40,000 = $777,000
- End Year 3: ($777,000 * 1.15) - $40,000 = $853,550
- End Year 4: ($853,550 * 1.10) - $40,000 = $898,905
- End Year 5: ($898,905 * 1.05) - $40,000 = $903,850.25
Bob's Portfolio:
- Start: $1,000,000
- End Year 1: ($1,000,000 * 1.05) - $40,000 = $1,010,000
- End Year 2: ($1,010,000 * 1.10) - $40,000 = $1,071,000
- End Year 3: ($1,071,000 * 1.15) - $40,000 = $1,191,650
- End Year 4: ($1,191,650 * 0.95) - $40,000 = $1,092,067.50
- End Year 5: ($1,092,067.50 * 0.90) - $40,000 = $942,860.75
Despite both portfolios having the same average return over five years, Alice's portfolio, subjected to early negative returns, ends significantly lower than Bob's. This illustrates the profound impact of Sequence of Returns Risk on a retiree's financial security, as Alice's portfolio has less capital remaining to generate future income.
Practical Applications
Sequence of Returns Risk is a paramount consideration in retirement income planning. Financial advisors employ various strategies to address this risk. One common approach is to implement a bucket strategy, where a portion of the portfolio is allocated to highly liquid, fixed income investments to cover early retirement expenses, safeguarding the more growth-oriented equity investments from being sold during a market downturn. Another application involves dynamic withdrawal strategies, where retirees adjust their spending based on market performance, potentially reducing withdrawals during periods of poor returns and increasing them during strong market conditions. This flexibility can significantly enhance portfolio longevity.
Furthermore, investors must consider the tax implications of withdrawals, as certain account types and tax treatments can influence a portfolio's resilience to adverse return sequences. For instance, understanding the different accounting methods and periods, as outlined by the IRS, can be crucial for tax planning around retirement withdrawals. https://www.irs.gov/pub/irs-pdf/p538.pdf
Many financial models, including Monte Carlo simulations, are used to test portfolio sustainability against thousands of possible return sequences, helping to quantify the probability of success and identify potential vulnerabilities to Sequence of Returns Risk. Discussions among individual investors also frequently center on practical ways to navigate this risk, often suggesting approaches like having a "buffer" of cash or conservative assets in the initial retirement years. https://www.bogleheads.org/wiki/Sequence_of_returns_risk
Limitations and Criticisms
While Sequence of Returns Risk is a critical concept, its primary limitation lies in its inherent unpredictability. No one can foresee the future sequence of market returns, making proactive mitigation a matter of probabilistic planning rather than deterministic prevention. Critics sometimes argue that overly conservative strategies implemented to avoid Sequence of Returns Risk might lead to "under-spending" in retirement, potentially leaving a larger legacy than intended. This can be viewed as an opportunity cost, as the portfolio may not grow as much as it could have with a more aggressive asset mix in the absence of adverse early returns.
Another point of discussion centers on whether the focus on Sequence of Returns Risk leads to an overemphasis on short-term market fluctuations rather than the long-term growth potential of a diversified portfolio. Some argue that flexible spending habits and the ability to return to work or find alternative income streams can naturally mitigate much of this risk, making complex pre-retirement adjustments less necessary. However, for those with less flexibility, the risk remains substantial. https://www.schwab.com/learn/story/timing-m...returns-risk
Sequence of Returns Risk vs. Withdrawal Rate
Sequence of Returns Risk and Withdrawal Rate are closely intertwined concepts in retirement planning, yet they represent distinct elements. The withdrawal rate is simply the percentage of a retirement portfolio withdrawn annually to cover living expenses. For example, a $40,000 withdrawal from a $1,000,000 portfolio represents a 4% withdrawal rate. This rate is a choice made by the retiree, often influenced by financial planning guidelines.
Sequence of Returns Risk, on the other hand, refers to the impact that the chronological order of investment returns has on the sustainability of a portfolio, especially when withdrawals are being made. It highlights that even if a chosen withdrawal rate is deemed "safe" on average, a period of poor market performance early in retirement can significantly jeopardize the portfolio's longevity.
The confusion often arises because a higher withdrawal rate can exacerbate Sequence of Returns Risk. If a retiree takes out a larger percentage of their portfolio each year, any early negative returns will necessitate selling a proportionally larger amount of assets, further depleting the principal. Conversely, a lower withdrawal rate provides a greater buffer against adverse return sequences. While the withdrawal rate is a static or semi-static decision, Sequence of Returns Risk is a dynamic market phenomenon that can undermine even a carefully chosen rate.
FAQs
What is the "danger zone" for Sequence of Returns Risk?
The "danger zone" for Sequence of Returns Risk is typically considered to be the period immediately before and during the first 5 to 10 years of retirement. During this time, retirees are beginning to draw income from their portfolios, and poor market performance can have a magnified negative impact on their capital base before it has had a chance to grow substantially. This period is when the investor has the least amount of time to recover from a market downturn.
How can I protect my portfolio from Sequence of Returns Risk?
Several strategies can help mitigate Sequence of Returns Risk. These include maintaining a more conservative asset allocation (e.g., higher allocation to bonds) in the early years of retirement, using a cash "bucket" strategy to cover initial expenses, adopting a flexible or dynamic withdrawal strategy that adjusts spending based on market performance, or delaying retirement if market conditions are unfavorable. Diversification across various asset classes can also help to smooth