Sequencing risk

What Is Sequencing Risk?

Sequencing risk, also known as sequence-of-returns risk, is the danger that the order of investment returns, particularly in the early years of withdrawing from a portfolio, will negatively impact the long-term sustainability of that portfolio. It is a critical concern within portfolio management and retirement planning, especially for individuals who are no longer contributing to their investments and have begun taking regular income. While average investment returns might appear sufficient over a long period, the actual order in which those returns occur can significantly affect the portfolio's longevity. Negative returns experienced early in the withdrawal phase necessitate selling more assets to meet income needs, leaving less capital to recover during subsequent market upturns.,⁴⁰,³⁹

History and Origin

The concept of sequencing risk gained prominence with the shift from traditional defined-benefit pension plans to defined-contribution plans, such as 401(k)s and IRAs, which place the responsibility of investment management and withdrawal strategies squarely on the individual. As more people entered retirement relying solely on their accumulated investment portfolios, the vulnerability of these portfolios to market downturns, especially early in retirement, became increasingly evident.³⁸

Financial researchers and planners began to quantify and highlight this risk, demonstrating how a series of poor investment returns at the onset of retirement could drastically shorten a portfolio's lifespan, even if the long-term average returns were favorable. This concern was particularly amplified after periods of significant market volatility, such as the dot-com bubble burst in the early 2000s or the 2008 financial crisis, which profoundly impacted retirees withdrawing funds from diminished portfolios.,³⁷ Michael Kitces, a prominent financial planning expert, has extensively discussed the dynamics of sequence of returns risk, including how it impacts retirement withdrawal strategies and the nuances of managing it effectively.³⁶

Key Takeaways

• Sequencing risk refers to the detrimental impact that the timing of investment returns can have on a portfolio, particularly when withdrawals are being made.
• It is most critical in the initial years of retirement, as early negative returns can significantly deplete the capital base, making it harder for the portfolio to recover.,³⁵
• Even if a portfolio achieves the same average return over a long period, a different sequence of returns (e.g., negative early, positive later) can lead to vastly different outcomes for portfolio longevity.³⁴,³³
• Managing sequencing risk often involves strategies like adjusting asset allocation, maintaining cash reserves, or employing flexible withdrawal rate strategies.³²

Interpreting Sequencing Risk

Interpreting sequencing risk involves understanding that the chronological order of returns matters profoundly when a portfolio is in its "decumulation" or spending phase. Unlike the accumulation phase, where negative returns can be offset by ongoing contributions and future compounding, during retirement, withdrawals amplify the impact of market downturns.³¹

If a portfolio experiences a bear market in the early years of retirement, the investor is forced to sell more shares or units at lower prices to generate the necessary income. This "dollar-cost ravaging" effect depletes the portfolio's principal more rapidly, leaving fewer assets to benefit from any subsequent market recovery. Conversely, if a retiree experiences strong positive returns early on (bull market), the portfolio grows, providing a larger base that can better withstand future periods of market volatility. Essentially, sequencing risk highlights that the timing of poor returns can be more damaging than the magnitude of those returns, especially when combined with systematic withdrawals.,³⁰,²⁹

Hypothetical Example

Consider two retirees, Alice and Bob, both starting retirement with an initial portfolio of $1,000,000 and planning to withdraw $50,000 annually (5% initial withdrawal rate). Both portfolios achieve an average annual return of 5% over 10 years, but the sequence of returns differs:

Alice's Scenario (Early Negative Returns):

• Year 1: -15% return (Portfolio after withdrawal: $1,000,000 * (1-0.15) - $50,000 = $800,000)
• Year 2: -10% return (Portfolio after withdrawal: $800,000 * (1-0.10) - $50,000 = $670,000)
• Year 3: +20% return (Portfolio after withdrawal: $670,000 * (1+0.20) - $50,000 = $754,000)
• ...and so on, with later years experiencing strong gains.

Bob's Scenario (Early Positive Returns):

• Year 1: +20% return (Portfolio after withdrawal: $1,000,000 * (1+0.20) - $50,000 = $1,150,000)
• Year 2: +15% return (Portfolio after withdrawal: $1,150,000 * (1+0.15) - $50,000 = $1,272,500)
• Year 3: -10% return (Portfolio after withdrawal: $1,272,500 * (1-0.10) - $50,000 = $1,095,250)
• ...and so on, with later years experiencing the same losses as Alice's early years.

Despite both portfolios having an average 5% return over the decade, Alice, facing negative returns early while making withdrawals, sees her capital deplete faster. She has fewer dollars left to recover when the market eventually performs well. Bob, who experienced positive returns initially, started with a larger base, making his portfolio more resilient to later downturns. This illustrates how systematic withdrawal plans can be significantly impacted by the sequence of returns.,²⁸

Practical Applications

Addressing sequencing risk is a cornerstone of robust financial planning for retirees. Several strategies are employed to mitigate its impact:

• Cash Buffer (Bucket Strategy): Many advisors recommend holding a portion of the portfolio (e.g., 1-5 years' worth of living expenses) in low-risk, liquid assets like cash or short-term bonds. This allows retirees to draw income from this "cash bucket" during market downturns, avoiding the need to sell equities at depressed prices and giving the growth-oriented portion of the portfolio time to recover.²⁷,²⁶,²⁵
• Dynamic Withdrawal Strategies: Rather than fixed annual withdrawals, retirees might adjust their spending based on market performance. During periods of poor returns, they may reduce withdrawals, and in strong market years, they might take out more or replenish their cash reserves.²⁴
• Asset Allocation Adjustments (Bond Tent/Glidepath): Some strategies suggest a higher allocation to less volatile assets, like bonds, in the years immediately preceding and following retirement, creating a "bond tent." As the portfolio weathers the initial withdrawal phase, the allocation can gradually shift back towards a higher equity exposure. This aims to protect capital during the period most vulnerable to sequencing risk.²³,²²
• Diversification: A well-diversified portfolio across different asset classes (stocks, bonds, real estate, etc.) can help smooth out returns, as not all asset classes move in perfect correlation.²¹,
• Guaranteed Income Streams: Incorporating guaranteed income sources, such as annuities, can reduce reliance on a volatile investment portfolio for essential expenses, thereby lessening the pressure of sequencing risk.²⁰

These practical applications aim to create a more resilient retirement income strategy, allowing investors to navigate unpredictable market conditions.¹⁹ A Reuters article from 2022 highlighted how bear markets specifically impact retirement portfolios by forcing withdrawals from a diminished base, underscoring the importance of these mitigation strategies.¹⁸

Limitations and Criticisms

While sequencing risk is a critical consideration in risk management, it's important to understand its nuances and limitations. One perspective is that while the risk is real, the impact is largely dependent on an investor's behavior and flexibility. An investor who can reduce spending during market downturns will be less affected by a poor sequence of returns than one who must maintain a rigid withdrawal schedule.¹⁷

Some criticisms or alternative views include:

• Behavioral Aspects: The theoretical models of sequencing risk often assume a constant, inflexible withdrawal rate. In reality, retirees may unconsciously or consciously adjust their spending during difficult market periods, which naturally mitigates some of the risk.¹⁶
• Upside of Favorable Sequences: Just as a bad sequence can be highly detrimental, a favorable sequence of returns can lead to significant outperformance and much more wealth than initially projected, potentially leading to underspending in retirement. Financial planning expert Michael Kitces explores this "extraordinary upside potential" of favorable return sequences, suggesting that overly conservative planning might result in retirees leaving substantial unspent wealth.¹⁵
• Time Horizon: The impact of sequencing risk is most acute in the initial 5-10 years of retirement. As the retirement period progresses, its influence tends to diminish, assuming the portfolio has weathered the initial phase successfully.¹⁴,¹³
• Focus on Average Returns vs. Sequence: While understanding the sequence is vital, it does not negate the importance of long-term average returns. Ultimately, if average returns are consistently too low, no sequence will save a portfolio from depletion.

Ultimately, while the mathematical reality of sequencing risk is undeniable, its practical impact on an individual's retirement depends heavily on their adaptive capacity, overall capital preservation strategies, and the dynamic management of their investment portfolio.¹²

Sequencing Risk vs. Longevity Risk

Sequencing risk and longevity risk are distinct but interconnected challenges in retirement planning.

Sequencing Risk focuses on the order of investment returns. It highlights how poor market performance, particularly in the early years of retirement when withdrawals are being made, can disproportionately deplete a portfolio, even if the average long-term returns are acceptable. The concern is that early losses lock in declines by forcing the sale of more assets to cover expenses, leaving less capital to recover during subsequent market upturns.,¹¹

Longevity Risk, on the other hand, is the risk of outliving one's financial resources. It concerns the possibility that an individual's lifespan will exceed the duration their retirement savings were designed to support. With increasing life expectancies and rising healthcare costs, ensuring a portfolio can last 20, 30, or even 40 years into retirement is a significant challenge.¹⁰,⁹

While sequencing risk deals with the timing of returns, longevity risk deals with the length of the retirement period. A negative sequence of returns can exacerbate longevity risk by causing a portfolio to deplete faster than expected, thereby increasing the chance that a retiree runs out of money prematurely. Conversely, managing sequencing risk effectively helps to safeguard the portfolio's principal, which in turn helps to mitigate longevity risk.⁸

FAQs

What causes sequencing risk?

Sequencing risk is caused by the combination of volatile investment returns and ongoing withdrawals from an investment portfolio, particularly in the absence of new contributions. When significant negative returns occur early in the withdrawal period, more assets must be sold to meet income needs, reducing the base for future growth and making it harder for the portfolio to recover.⁷,⁶

Is sequencing risk only a concern for retirees?

While sequencing risk is most pronounced and impactful during the retirement "decumulation" phase when regular withdrawals begin, the underlying phenomenon of return order affecting portfolio value can technically exist in any period with cash flows (contributions or withdrawals) and market volatility. However, its consequences are far more severe for retirees who rely on their portfolios for living expenses and have less time to recover from downturns.⁵,⁴

Can sequencing risk be completely eliminated?

No, sequencing risk cannot be entirely eliminated because it is tied to unpredictable market volatility. However, it can be significantly mitigated through various strategies like strategic asset allocation, maintaining cash reserves, flexible spending adjustments, and potentially incorporating guaranteed income streams. The goal is to reduce its impact rather than remove it entirely.³,²

How does inflation affect sequencing risk?

Inflation can exacerbate sequencing risk by increasing the real dollar amount needed for living expenses over time. If withdrawals need to increase annually to maintain purchasing power while negative returns are simultaneously depleting the portfolio, the combined effect can accelerate the depletion of retirement savings.¹