What Is Sequence Risk?
Sequence risk, also known as sequence-of-returns risk, is the danger that the timing of investment returns, particularly poor ones, will negatively impact the long-term sustainability of a portfolio, especially during periods of portfolio withdrawals. This phenomenon is a critical consideration within retirement planning and a subset of broader portfolio theory. It emphasizes that the order in which investment returns occur is often more significant than the average return itself, particularly when an investor is drawing income from their portfolio. Early negative returns can significantly deplete the portfolio's principal, leaving less capital to benefit from future market recoveries and potentially shortening the portfolio's investment horizon.
History and Origin
The concept of sequence risk gained prominence with the shift from traditional defined-benefit pension plans to defined-contribution plans, where individuals became increasingly responsible for managing their own retirement savings and withdrawals. As more individuals began to rely on their investment portfolios for retirement income, the vulnerability of these portfolios to market fluctuations during the payout phase became a significant concern. The work of financial planner William P. Bengen in 1994, which explored historical market returns to determine sustainable withdrawal rate for retirees, helped to highlight the critical role of the sequence of returns. His research demonstrated that the success or failure of a retirement plan could heavily depend on the market performance in the initial years of retirement, rather than just the overall average return over the entire period. This insight underscored the unique challenges faced by retirees compared to accumulators, where early losses can be particularly detrimental7.
Key Takeaways
- Sequence risk is the danger that the order of investment returns, especially negative ones early in retirement, can significantly impair a portfolio's longevity.
- It primarily affects individuals who are actively withdrawing funds from their portfolios, such as retirees.
- Early market downturns reduce the portfolio's principal at a time when withdrawals are occurring, leaving less capital to recover and grow.
- Strategies to mitigate sequence risk often involve adjusting asset allocation, implementing flexible withdrawal strategies, and maintaining cash reserves.
- Understanding sequence risk is crucial for robust financial planning and effective risk management in the decumulation phase.
Interpreting the Sequence Risk
Interpreting sequence risk involves understanding that while long-term average investment returns might seem sufficient, the specific timing of those returns can drastically alter outcomes. For example, a retiree who experiences a substantial bear market in the first few years of retirement, while simultaneously making portfolio withdrawals, will likely face a much greater challenge in sustaining their portfolio than someone who experiences strong early returns, even if both portfolios have the same average return over a 30-year period. This is because withdrawals during a market downturn force the sale of assets at depressed prices, permanently reducing the asset base from which future gains can compounding. It underscores the importance of managing volatility and having a robust strategy for the initial years of retirement.
Hypothetical Example
Consider two hypothetical retirees, Alice and Bob, who both start retirement with $1,000,000 and plan to withdraw $40,000 (4%) annually, adjusted for inflation. Both portfolios earn an average annual return of 7% over 20 years.
Scenario 1: Alice (Negative Returns Early)
| Year | Starting Balance | Return (%) | Withdrawals | Ending Balance |
|---|---|---|---|---|
| 1 | $1,000,000 | -10% | $40,000 | $860,000 |
| 2 | $860,000 | -5% | $41,200 | $775,800 |
| 3 | $775,800 | +20% | $42,436 | $888,292.80 |
| ... | (Subsequent years with positive returns averaging 7%) | |||
| 20 | $450,000 (approx) |
In Alice's case, the early negative returns significantly deplete her principal. Even though subsequent years may see good returns, the reduced base means less capital is available to grow, making it harder for her portfolio to recover.
Scenario 2: Bob (Positive Returns Early)
| Year | Starting Balance | Return (%) | Withdrawals | Ending Balance |
|---|---|---|---|---|
| 1 | $1,000,000 | +20% | $40,000 | $1,160,000 |
| 2 | $1,160,000 | +10% | $41,200 | $1,234,800 |
| 3 | $1,234,800 | -5% | $42,436 | $1,130,620.40 |
| ... | (Subsequent years with returns averaging 7% overall) | |||
| 20 | $1,500,000 (approx) |
Bob, despite having the exact same average 7% return over 20 years, experiences positive returns early on. This allows his portfolio to grow substantially before encountering any downturns, providing a larger base for growth and making his withdrawal rate more sustainable. This example highlights how the timing—or sequence—of returns dramatically affects the long-term viability of a portfolio during the decumulation phase.
Practical Applications
Sequence risk is a paramount consideration in modern retirement planning. Financial professionals apply various strategies to mitigate its impact, particularly for individuals nearing or in the early stages of retirement. One common approach involves adjusting asset allocation to hold a larger proportion of conservative assets, such as cash or bonds, in the initial years of retirement. This "bond tent" or cash buffer strategy aims to provide a pool of funds for portfolio withdrawals without being forced to sell growth-oriented assets during a market downturn.
A6nother practical application involves implementing flexible withdrawal rate strategies. Instead of rigid inflation-adjusted withdrawals, retirees might reduce their spending in years following poor market performance, allowing their portfolio more time to recover. This adaptive approach can significantly improve the longevity of retirement savings, especially if a bear market occurs early in retirement. Ad5ditionally, rebalancing a portfolio regularly can help manage risk exposures and realize gains from strong-performing assets, which can then be used to bolster positions in underperforming assets or refill cash reserves. Discussion forums, such as those provided by the Bogleheads community, offer practical insights and shared experiences on managing this risk through conservative investment principles and sound risk management strategies.
#3, 4# Limitations and Criticisms
While sequence risk is a critical concept in retirement planning, it also faces certain nuances and interpretations. Some critics argue that its emphasis can lead to overly conservative asset allocation choices that might compromise long-term portfolio growth, especially if the investment horizon is longer than typical retirement periods. An overly cautious approach, focused intensely on capital preservation in early retirement, could potentially lead to the portfolio failing to keep pace with inflation over decades, thereby introducing its own set of risks.
Furthermore, some academic discussions suggest that while the degree of exposure to sequence risk changes over time, it may never entirely disappear as long as regular cash flows occur. Th2is perspective implies that a continuous awareness and flexible approach to portfolio withdrawals are always necessary. Measuring sequence risk itself can be complex, and various methodologies exist, some of which attempt to quantify the probability of an investment strategy failing to deliver desired withdrawal rates based on return sequences. Ul1timately, the challenge lies in balancing the need to mitigate early-retirement market downturns with the necessity for sufficient growth to sustain a portfolio over an entire retirement, which could span 30 years or more.
Sequence Risk vs. Longevity Risk
Sequence risk and longevity risk are two distinct but interconnected threats to a successful retirement. Sequence risk, as discussed, pertains to the order of investment returns and its disproportionate impact on a portfolio when withdrawals are occurring, particularly poor returns in the early years of retirement. It is about the timing of market performance relative to the start of withdrawals.
In contrast, longevity risk is the risk of outliving one's savings. This risk arises from the uncertainty of an individual's lifespan; people are living longer, on average, than in previous generations, which means retirement portfolios may need to sustain income for 30 or even 40 years. While sequence risk can cause a portfolio to deplete faster than expected, longevity risk highlights the fundamental challenge of ensuring sufficient funds for an unexpectedly long life. An individual might manage sequence risk effectively through prudent dollar-cost averaging or a cautious withdrawal rate, but still face longevity risk if their assets, even if managed well, are simply not enough to cover expenses for a very extended retirement period. Both risks require careful consideration in financial planning to ensure a secure retirement.
FAQs
What does "sequence risk" mean in simple terms?
Sequence risk means that the order of your investment gains and losses matters a lot, especially when you start taking money out of your investments, like in retirement. If you experience big losses early on while you're making withdrawals, your money might run out much faster than if those same losses happened later, even if the average returns over your entire retirement are the same.
Why is sequence risk particularly relevant for retirees?
Sequence risk is most relevant for retirees because they are typically no longer contributing new money to their portfolios but are actively withdrawing funds. When a market downturn occurs early in retirement, these withdrawals lock in losses by forcing the sale of assets at lower prices, significantly reducing the base amount available to recover and grow in the future. This can severely shorten the life of their retirement savings.
How can investors protect against sequence risk?
Investors can protect against sequence risk through several strategies. These include building a cash reserve or "bond tent" to cover early retirement expenses, allowing them to avoid selling stocks during market downturns. Diversifying asset allocation across different asset classes can also help. Additionally, having a flexible withdrawal rate that can be reduced during poor market years, and considering a slightly lower initial withdrawal rate overall, can improve a portfolio's resilience.
Does sequence risk go away after a few years of retirement?
While the impact of sequence risk is generally most severe in the initial years of retirement, particularly the first 5-10 years, some financial researchers suggest it never entirely disappears as long as you are making withdrawals and your portfolio is exposed to market volatility. Its influence diminishes over time as the portfolio's remaining value and future growth have a longer period to offset early losses. However, continuous monitoring and adaptive strategies remain prudent.
Is there a formula to calculate sequence risk?
Sequence risk is not typically calculated with a single formula, but rather assessed through financial modeling techniques like Monte Carlo simulations. These simulations run thousands of possible scenarios of market returns and withdrawals to estimate the probability of a portfolio lasting through a given retirement period, accounting for the random order of returns. This helps illustrate the potential impact of different return sequences on portfolio longevity.