Sequence of Return Risk
Have you heard about “sequence of return risk”? Probably not.
Too often do those of us inside the industry take our knowledge for granted. Assuming average investors understand the complexities of finance can lead to confusion and lack of clarity. It is a tendency I’m certainly guilty of and something I’m making efforts to correct. Explaining financial planning topics in a way regular people can grasp is important. With that in mind, I’d like to start utilizing this blog more often to educate readers on topics worthy of attention. I’ll start today…
What is Sequence of Return Risk?
The sequence of return risk is most commonly associated with safe withdrawal rates for retirement portfolios. The safe withdrawal rate is the amount of money one can safely withdraw from a portfolio each year without running out of money before death. We’ll begin with a quick example of how the sequence of returns generated in a portfolio will matter a great deal.
Ignoring any cash flows in or out of the portfolio, a $1,000,000 portfolio that returns 100% one year and loses 50% the next year ends up in the same place as a portfolio that loses 50% the first year and gains 100% the second. After two years, both portfolios are worth $1,000,000. In both cases, the arithmetic average return was 25% ((100-50)/2) and the geometric (compound) average return was 0%.
So no cash flows, no big deal. The order of returns doesn’t really matter. What happens if we include cash flows, though?
Now assume that after the first year the investor has to withdraw $500,000 from the portfolio to make a payment. In the first scenario (year 1=+100%, year 2=-50%), the portfolio would be worth $1,500,000 after the withdrawal at the end of year 1, and $750,000 after a 50% decline in year 2. In the second scenario (year 1=-50%, year 2=+100%), the portfolio would be worth $0 after the withdrawal at the end of year 1 and still $0 at the end of year 2! In this case, the 100% return in year 2 doesn’t matter because there was no money left to invest!
Why Sequence Risk Matters
Let’s consider a real-world example of sequence risk. A 65-year-old investor with a $1,000,000 portfolio decides she’d like to retire. To maintain her current lifestyle, she needs to withdraw $60,000 a year from the portfolio. She thinks she will live for another 30 years and believes she’ll have an average rate of return of 5% over that timeframe. In each scenario outlined below, the average return is 5%. The only difference is the order that the returns occur.
Scenario 1: 5% returns every year.
Scenario 2: 15% returns in years 1 and 2, 5% returns years 3-28, -5% returns in year 29 and 30.
Scenario 3: -5% returns in years 1 and 2, 5% returns years 3-28, 15% returns in year 29 and 30.
As you can see, a small change in the sequence of returns can make a big difference for the investor. In the example above, losing 5% in each of the first two years of retirement results in the investor running out of money when she is 88 years old. That is seven years earlier than she planned!
More Than Returns
A common concern of many people who plan to retire in the next several years relates to this sequence risk. From a historic perspective, stock valuations in the U.S. are elevated. Given how much markets have rallied over the past seven years, the worries future retirees face are understandable. A weak stock market that results in a modest decline of a retiree’s portfolio can have meaningful consequences.
Using safe withdrawal rates, dynamic asset allocation or dynamic spending strategies are some methods that can be used to mitigate sequence of return risk. Each topic is worthy of its own discussion and beyond the scope of this post. The goal here was to simply to describe sequence risk and make you aware of the issue. The order of returns matter as much as the returns themselves. Hopefully, you now have a better understanding at one risk that keeps many retirees up a night!
At Ariadne, I work closely with families and individuals to organize their finances and utilize their resources to design a life they love. If you are interested in a straightforward, no-gimmick approach to financial planning that focuses on you and your needs, don’t hesitate to get in touch. I’d be happy to have a conversation.