Sequence of returns risk

Sequence of returns risk is a critical concept in financial risk management, particularly for individuals relying on a portfolio for income, such as retirees. This risk highlights that the order, or sequence, in which investment returns occur can significantly impact the long-term sustainability of a portfolio, even if the average annual return over a prolonged period is the same. Unlike the accumulation phase where negative returns can be offset by future contributions and market recovery through compounding, during the decumulation (withdrawal) phase, early negative returns can severely deplete a portfolio, leaving less capital to recover when markets eventually rebound. This phenomenon makes a portfolio highly vulnerable, especially in the years immediately before and after retirement, often referred to as the "retirement risk zone" or "fragile decade."²⁰, ²¹

History and Origin

While the underlying mathematical concept of how the order of events affects outcomes in certain scenarios has always existed, the recognition and emphasis of "sequence of returns risk" as a distinct financial planning concern gained prominence with the shift from defined benefit pension plans to defined contribution plans. In defined benefit plans, the employer bears the investment risk, guaranteeing a fixed income stream. However, in defined contribution plans (like 401(k)s), individuals bear the investment risk, making the impact of market fluctuations, particularly at critical junctures, a direct personal concern.¹⁹

A significant contribution to understanding this risk came from academic studies on sustainable withdrawal rates, notably the "Trinity Study" (named after Trinity University where its authors were professors) published in 1998. This paper, "Retirement Savings: Choosing a Sustainable Withdrawal Rate," explored the long-term success rates of various stock and bond portfolios with different withdrawal percentages. While not explicitly coining the term "sequence of returns risk," the study's findings implicitly underscored its importance by demonstrating how the historical sequence of market returns significantly influenced the longevity of retirement portfolios, even with identical average returns.¹⁸ Researchers like Wade Pfau have continued to build on this work, further highlighting how the timing of market downturns early in retirement can profoundly impact a portfolio's longevity.¹⁷

Key Takeaways

• Timing Matters: The order of investment returns has a disproportionately large impact on portfolio longevity during the withdrawal phase compared to the accumulation phase.
• Early Losses are Most Damaging: Negative returns experienced early in retirement, especially when withdrawals are being made, can severely deplete a portfolio, making it harder for the remaining assets to recover.
• Affects Sustainability: Sequence of returns risk can jeopardize the long-term sustainability of a retirement income stream, potentially forcing retirees to reduce their sustainable spending or even run out of money.
• Beyond Average Returns: While long-term average returns might look favorable, a poor sequence of returns can lead to very different outcomes, even if the overall average is the same.¹⁶
• Mitigation Strategies Exist: There are various strategies investors can employ to mitigate the impact of sequence of returns risk, such as adjusting asset allocation or modifying withdrawal patterns.

Formula and Calculation

Sequence of returns risk does not have a single, universally applied formula like a financial ratio. Instead, its impact is typically demonstrated and analyzed through simulations that model different sequences of returns.¹⁵

For illustrative purposes, one can conceptualize the portfolio value (PV) at any given time (t) with withdrawals (W_t) and returns (R_t) as:

$PV_t = PV_{t-1} \times (1 + R_t) - W_t$

Where:

• (PV_t) = Portfolio value at the end of year (t)
• (PV_{t-1}) = Portfolio value at the end of the previous year (or beginning of current year)
• (R_t) = Investment return for year (t)
• (W_t) = Withdrawal made during year (t) (often adjusted for inflation)

The "risk" comes from the non-linear interaction between (R_t) and (W_t). If (R_t) is significantly negative early in the withdrawal period, the base (PV_{t-1}) is substantially reduced. Subsequent positive returns then apply to a much smaller base, making recovery more challenging. This effect is often explored through Monte Carlo simulation, which runs thousands of scenarios with randomized sequences of returns to assess the probability of a portfolio's success.

Interpreting the Sequence of Returns Risk

Interpreting sequence of returns risk primarily involves understanding its heightened importance during specific phases of an individual's financial life, particularly around retirement. For an investor accumulating wealth over a long investment horizon, the order of returns matters less because regular contributions can average out market fluctuations; poor returns are offset by buying more assets at lower prices. However, when an individual transitions to drawing income from their portfolio, a period often referred to as the "fragile decade" (approximately 5-10 years before and after retirement), the impact of return sequencing becomes critical.¹⁴

A sharp decline in portfolio value early in retirement, combined with ongoing withdrawals, means that more shares of assets must be sold at depressed prices to meet living expenses. This drastically reduces the portfolio's base, leaving less capital available to benefit from future market recoveries and potentially shortening the overall lifespan of the retirement savings.¹², ¹³ Conversely, strong early returns can create a larger buffer, making the portfolio more resilient to later downturns. Therefore, interpreting this risk means recognizing that the timing of market volatility can be more impactful than the volatility itself when income is being drawn.

Hypothetical Example

Consider two retirees, Alice and Bob, both starting retirement with a portfolio of $1,000,000 and planning to withdraw $50,000 per year (5% initial withdrawal rate), adjusted for 3% inflation annually. Both experience the same average annual return of 7% over 20 years, but the sequence of these returns differs.

Scenario 1: Alice (Negative Returns Early)
Alice experiences significant negative returns in her first few years of retirement, followed by strong positive returns.

• Year 1: Market return -15%. Alice withdraws $50,000. Her portfolio drops to ($1,000,000 * 0.85) - $50,000 = $850,000 - $50,000 = $800,000.
• Year 2: Market return -10%. Alice withdraws $51,500 (adjusted for inflation). Her portfolio drops to ($800,000 * 0.90) - $51,500 = $720,000 - $51,500 = $668,500.
• Year 3: Market return -5%. Alice withdraws $53,045. Her portfolio drops to ($668,500 * 0.95) - $53,045 = $635,075 - $53,045 = $582,030.
• Subsequent years: While Alice experiences high positive returns later, the severe early depletion means she is drawing from a much smaller base. Her portfolio might run out of money much sooner, or she might be forced to drastically cut her spending.

Scenario 2: Bob (Positive Returns Early)
Bob experiences strong positive returns in his first few years, followed by negative returns later.

• Year 1: Market return +15%. Bob withdraws $50,000. His portfolio grows to ($1,000,000 * 1.15) - $50,000 = $1,150,000 - $50,000 = $1,100,000.
• Year 2: Market return +10%. Bob withdraws $51,500. His portfolio grows to ($1,100,000 * 1.10) - $51,500 = $1,210,000 - $51,500 = $1,158,500.
• Year 3: Market return +5%. Bob withdraws $53,045. His portfolio grows to ($1,158,500 * 1.05) - $53,045 = $1,216,425 - $53,045 = $1,163,380.
• Subsequent years: Even if Bob experiences negative returns later, his portfolio has a larger base, allowing it to absorb losses more effectively and sustain his financial planning much longer.

This example illustrates how the sequence of returns, not just the average return, can dictate vastly different outcomes for individuals drawing income from their portfolios.

Practical Applications

Understanding sequence of returns risk is crucial in several areas of portfolio management and financial planning:

• Retirement Income Planning: This is the primary application. Financial advisors use the concept to educate clients about the importance of market timing, particularly during the years immediately preceding and following retirement. Strategies like dynamic spending rules, which adjust withdrawals based on market performance, are employed to mitigate this risk.¹¹
• Asset Allocation Adjustments: As individuals approach retirement, many advisors recommend a gradual shift towards a more conservative asset allocation, often referred to as a "glide path," to reduce exposure to significant bear market losses early in the withdrawal phase.¹⁰ However, some research suggests target-date funds, which employ glide paths, have not fully protected against this risk in the past.⁹
• Cash Flow Buffers: Establishing a cash reserve or "bucket" of liquid assets for 1-3 years of living expenses can provide a buffer, allowing retirees to avoid selling growth-oriented assets during market downturns. This helps preserve the principal for future recovery.⁸
• Contingency Planning: For those entering retirement, it's essential to have contingency plans, such as the flexibility to reduce spending, seek part-time work, or delay Social Security claims, should an unfavorable sequence of returns occur. The long-term impact of market and labor market fluctuations on older workers' retirement security has been a subject of research.⁷
• Investment Product Design: The recognition of sequence risk has influenced the development of investment products designed to provide more stable income streams or protect against early market declines, such as certain types of annuities or structured products.

Limitations and Criticisms

While sequence of returns risk is a significant concern, especially for retirees, its management comes with certain limitations and criticisms:

• Trade-offs with Growth: Aggressively de-risking a portfolio to avoid early negative returns might lead to lower overall returns and a reduced potential for long-term portfolio growth. This could inadvertently increase longevity risk if the portfolio cannot keep pace with inflation or fund a very long retirement.⁶
• Complexity of Mitigation Strategies: Strategies like dynamic withdrawal rules or bucketing can add complexity to a retirement plan. They require discipline and a willingness to adjust spending, which may not be suitable for all retirees.
• No Crystal Ball: Despite advanced risk management techniques and simulations, predicting the exact sequence of future market returns is impossible. Therefore, all mitigation strategies are based on probabilities and historical data, not guarantees.
• Focus on Retirement Phase: The concept's primary focus is on the decumulation phase of retirement. While some studies suggest it can also affect the accumulation phase, its impact is far less pronounced when regular contributions are being made.⁴, ⁵
• Behavioral Challenges: Even with a sound plan, experiencing significant losses early in retirement can be emotionally taxing. This can lead to panic selling or irrational financial decisions, undermining carefully constructed strategies. Maintaining a capital preservation mindset can be challenging during volatile periods.
• Overemphasis on Worst-Case: While important to plan for, focusing solely on worst-case sequence scenarios might lead to overly conservative portfolios that compromise quality of life in retirement. Academic research continues to explore optimal withdrawal strategies that balance risk and return.³

Sequence of Returns Risk vs. Longevity Risk

Sequence of returns risk and longevity risk are both critical challenges in retirement planning, but they refer to distinct concepts:

In essence, sequence of returns risk is about the efficiency with which your money lasts given market performance, while longevity risk is about whether your money lasts long enough regardless of market performance. Both require careful consideration in robust financial planning.

FAQs

What is the "fragile decade" in the context of sequence of returns risk?

The "fragile decade" refers to the period roughly 5 to 10 years immediately before and after retirement.² During this time, a portfolio is at its peak value, and withdrawals are beginning. Experiencing significant negative investment returns during this window can have a disproportionately large and detrimental impact on the long-term sustainability of retirement savings, making the portfolio particularly "fragile."

Does sequence of returns risk affect investors during their working years?

While the mathematical effect of return sequencing technically exists during the accumulation phase, its impact is generally considered negligible compared to the retirement phase. During working years, regular contributions can offset negative returns by allowing investors to buy more assets at lower prices (a concept known as dollar-cost averaging). This helps average out the returns over time. The risk becomes critical only when withdrawals begin and contributions cease.

How can I protect my retirement savings from sequence of returns risk?

Several strategies can help mitigate sequence of returns risk. These include establishing a cash buffer (e.g., 1-3 years of living expenses) to avoid selling investments in a down market, maintaining flexibility with your withdrawal rate (reducing spending during downturns), adjusting your asset allocation to be more conservative as you approach and enter retirement, and exploring income-generating assets like annuities.¹ It is important to work with a financial professional to create a personalized retirement planning strategy.