Sequence of returns risk refers to the risk of experiencing a bear market early in the life of a portfolio, rather than later, and how that can impact the longevity of a portfolio. This risk is typically mostly associated with a retirement (or distribution) portfolio where the investor is withdrawing money on a regular basis to fund lifestyle.
The best way to understand sequence of returns risk is to see an example of two portfolios that have the same average annual returns over a length of time. No matter the order of the returns, if the investor is not drawing on the portfolio, the two portfolios will end with the same balance at the end of the time period. If the investor is drawing on the balance, however, during a retirement phase, the order of the returns can lead to very different outcomes for the portfolios. This is called sequence of returns risk, and we will demonstrate this example and discuss further.
Sequence of returns risk example
The following example shows two portfolios. Both have annual returns of roughly 6.6%. The starting balance is $1,000,000 and each portfolio over 25 years results in a balance of just over $5,000,000. You’ll notice that the first portfolio has a bear market very early in the 25 year span, and the second portfolio has a bear market later in the 25 year span. As a result, you’ll see the path to the $5,000,000 resulting balance varies much between the two portfolios, but the key is that they both result in the same outcome. The first portfolio with the early bear market is able to catch up and get to the same outcome.
This graphic shows the year-by-year returns and balance between the early bear market portfolio and the later bear market portfolio.
Now, we can take this data and put it into a line graph to see more visually how both portfolios follow very different paths, but end up at the same result. Of course, this is the essence of much of financial planning. Even with large drawdowns from time to time, historic averages in stock market returns give us confidence that we will grow our money over time in a sufficient manner. Notice how the “early bear market” portfolio (blue line) takes a while to get going, but eventually catches up. Again both portfolios have annualized returns of about 6.66%, but with very different single year returns at various times.
The key takeaway: Two portfolios with the same average annual returns will end up at the same spot no matter how much the single year returns vary as long as the investor is not drawing on the portfolio.
Now that we have established that the portfolios end up at the same destination in the scenario where the investor is not drawing on the money, let’s bring this home with showing what happens when the investor is drawing a reasonable amount of money each year to fund lifestyle (e.g. during retirement).
We will use the same exact returns and portfolios for this example, but now we will layer in a withdrawal amount. The withdrawal amount will start at $50,000 and increase by 2.5% each year for inflation. Let’s look at the year-by-year data:
Uh oh, you’ll notice something pretty quickly here. The early bear market portfolio runs out of money about 14 years into our scenario. Despite some big annual gains starting around year 9, it’s not enough to catch up after experiencing a big bear market in the first couple years of the portfolio. Contrast this with the early bull market portfolio which doesn’t just not run out of money, but the overall portfolio balance continues to grow even while the investor is drawing on the balance.
Again, let’s look at the line chart to see the difference visually:
As you can see the blue line represents the early bear market portfolio and clearly shows hitting the zero balance at year 14. Not good!
This is a clear example of sequence of returns risk. Despite having the same average returns over time, one portfolio is a smashing success and the other is a disaster for the retiree. The cause is nothing more than the timing of when market turmoil hits the portfolio.
Why does this happen? Well to withdraw money, assets are sold to raise cash. When a bear market depresses the prices of the assets inside a portfolio, more shares or assets are required to be sold in order to raise enough cash to meet the withdrawal. Since more shares are sold at lower prices, there are now fewer shares to participate in a potential rebound afterwards. By withdrawing money during a major market decline, the investor is essentially locking in losses or making some of these losses permanent.
Some financial advisors equate this situation to the opposite of dollar cost averaging. While an investor in an accumulation portfolio dollar cost averages over time, buying shares continually even during a bear market, the investor that buys more shares at lower prices has even more shares that then participate in a stock market recovery. Dollar cost averaging is quite beneficial to investors over time and helps investors weather bear markets during the accumulation phase of investing.
So, to sum up the concept of sequence of returns risk: a bear market early in the lifespan of a withdrawal or retirement portfolio can have major effects on the longevity of the portfolio. Retirees need to be keenly aware of this risk, understand the “luck” of market returns that is involved and have plans to manage this risk depending on the other variables of his or her financial situation.
Does asset allocation help with sequence of returns risk?
Can we manage sequence of returns risk with a proper asset allocation? The results are limited. Asset allocation is most important for accumulation mode investing where we’re attempting to manage the overall volatility and achieve a certain level of average returns over time while accepting a certain amount of risk. The problem with asset allocation impacting sequence of returns risk is that asset allocation is mostly useful for normal market behavior which constitutes let’s say somewhere between 95-98% of the time. The 2-5% of market behavior that is marked by extreme volatility and major market crashes is main concern when we’re talking about sequence of returns risk.
So, let’s look at some examples of how things could play out with some a few different typical asset allocation scenarios. We’ll use the Vanguard data of various allocations which give us average annual returns, worst year and best year for various stock/bond splits. Here’s what Vanguard says about the following asset allocations during the 1926-2018 history of markets:
80% stocks / 20% bonds:
- Average annual return: 9.4%
- Best year: 45.4%
- Worst year: -34.9%
70% stocks / 30% bonds:
- Average annual return: 9.1%
- Best year: 41.1%
- Worst year: -30.7%
60% stocks / 40% bonds:
- Average annual return: 8.6%
- Best year: 36.7%
- Worst year: -26.6%
50% stocks / 50% bonds:
- Average annual return: 8.2%
- Best year: 32.3%
- Worst year: -22.5%
40% stocks / 60% bonds:
- Average annual return: 7.7%
- Best year: 27.9%
- Worst year: -18.4%
So, our goal is to run some simulations across these various stock/bond splits and see how much asset allocation impacts portfolio longevity in the scenario where the investor gets unlucky with respect to sequence of returns. We’ll first look at the scenario where initial withdrawal amount is $40,000, then we’ll look at the scenario where the initial withdrawal amount is $50,000.
In each scenario, we utilize average returns as listed above for each allocation model, and the first year has the worst year for that allocation split.
$40,000 Initial Withdrawal (Increases by 2.5% annually)
As you can see in the above information, with a $40,000 initial withdrawal, all portfolios survive the 25 year time frame. The performance varies somewhat, but the key is that each allocation leads to a scenario where the retiree does not run out of money.
$50,000 Initial Withdrawal (Increases by 2.5% annually)
When we increase the initial withdrawal to $50,000, you can see that every scenario results in the retiree running out of money.
What can we take away from this? Is asset allocation meaningless? Of course not. Properly thinking through your asset allocation is one of the key decisions of financial planning. It is a crucial decision based on your expenses and risk profile. It should not be taken lightly.
However, what this shows is that when it comes to portfolio longevity and what factor contributes the most to whether or not you will have enough money, asset allocation comes in third, at best, behind luck and withdrawal rate. These examples above outline extremely unlucky situations (year 1 is the worst year that should happen in these asset allocation models). However, withdrawal rate is even more key. As shown above, with an initial $40,000 withdrawal, all portfolios survived even one of the most unlucky scenarios. And, similarly, all portfolios did not survive when initial withdrawal was $50,000.
So, when it comes to what matters most in retirement, you can assume the following order:
- Withdrawal rate (how much money you’re pulling out weighed against how much money you have)
- Luck with sequence of returns (a bad bear market early in your retirement is unlucky, a raging bull market early in retirement is lucky)
- Asset allocation
How to manage sequence of returns risk
We’ve shown that asset allocation is not a smart strategy to managing sequence of returns risk. So what can we do? How can retirees sleep well at night despite knowing they might get “unlucky” and get a bear market early in their retirement years? Let’s look at a few ways to manage sequence of returns risk:
Ensuring a conservative withdrawal rate
While you cannot control market returns and the timing of them, the one thing you can control as a retiree is the withdrawal rate on your portfolio. Of course this can have lifestyle implications, but it’s an important discussion point. First, let’s eliminate the extreme situations from the scenario. Obviously, if you’re retiring with $50 million in assets and need to withdraw $100,000/year to live, you’re going to be fine regardless of the sequence of returns. Also, if you’re retiring with very little money and your required funds make the likelihood of running out of money very high, then you’ll want to go with an alternative approach most likely. Check out the last method described below when we discuss using guaranteed income streams rather than simply hoping and praying for the stock market to bail you out.
Let’s re-work our previous example and reduce our withdrawal rate to see how that helps the early bear market portfolio. We started previously with a $50,000 withdrawal that increased 2.5% per year. With a starting balance of $1,000,000, that’s a 5% withdrawal rate. In many financial circles, 5% is considered too high. 4% is usually the standard “safe withdrawal rate,” but I’ve seen some advisors recommend being even more conservative. Let’s look at a few examples of varying withdrawal rates with the same exact sequence of returns as we looked at above for the early bear market.
As you’ll notice above, sequence of returns risk still dooms the portfolio when we change from the initial 5% withdrawal rate down to the 4% withdrawal rate. When starting with a $40,000 withdrawal and increasing it by 2.5% each year, we still run into a problem and run out of money in year 22.
Once we get to a 3.5% withdrawal rate and below, the portfolio survives. The 3% withdrawal rate, the portfolio even grows despite a really ugly early bear market. The following chart shows the portfolio performance for each of the three scenarios:
Reduce withdrawals during a market downturn
Since the main problem we’ve illustrated in this article is withdrawing money when the market has depressed our investments, what if we simply adjust our withdrawal during the rare occasions of major market moves lower? It’s a reasonable thought process. Let’s see how it might work in our example.
Let’s use the $40,000 initial withdrawal with 2.5% annual growth, but in the event that the returns are -5% for the year or worse, let’s reduce the withdrawal amount by a fixed amount. We will consider reductions of $4,000, $8,000 and $12,000. Note that in this situation we will put the subsequent year withdrawal at the amount it would have been had no reductions occurred including the 2.5% annual growth rate (so the reduction will have not impact subsequent years). In the chart below, highlighted cells represent reduction withdrawal years.
As shown above, the reduced withdrawal amount in ugly market years does help. However, only until we get to the $12,000 reduction does the money last the entire 25 year time span. And, of course reducing a withdrawal amount from $40,000 to $28,000 would be quite painful to the investor.
Here’s one more look at the performance over time of each reduction plan:
In an ideal situation, you have other sources of income such as social security and maybe even a pension where you have a very conservative withdrawal rate. If you can save enough plus add in things like social security and achieve something like a 2 – 2.5% withdrawal rate, you can nearly eliminate sequence of returns risk and most likely leave your children a nice estate when you’re gone.
Have a chunk of cash in reserve
A popular strategy for actual people approaching retirement (as opposed to studies written in financial publications) is to have a chunk of money that is outside your investment portfolio. One of the main inputs to retirement planning is your estimated annual expenses. Once you know how much money you need each year in retirement, you can determine the amount of cash you want to set aside. Many opt for something like 3 years of expenses.
If you have a chunk of cash outside the market, this can be instrumental in managing a situation where a bear market arises during the initial years of retirement. Rather than drawing on the investment portfolio and selling assets at a loss in order to raise cash, the retiree can draw on the cash asset and leave the investments in tact. Even if the cash balance dwindles and eventually goes away, this can be an acceptable scenario since we know that our goal is to ensure that we can weather bear markets early in the lifespan of our retirement portfolio.
This can also be a solid approach in the event that an individual retires before something like social security kicks in. Having an extra cash buffer during early years can ensure that a retiree can get through to the years when social security kicks in without damaging the long-term retirement portfolio.
Lastly, there might be some tax benefits to having some cash that can be drawn on as well even in the event that no bear market materializes. Obviously drawing on cash does not result in a taxable event (or a minimal taxable event) compared to selling stock market assets for larger capital gains.
Utilizing guaranteed income streams instead of market investments
In the situation where it’s very likely that any bad luck in the market could lead to running out of money, it can make sense to eliminate the market risk altogether. This can be done by purchasing an annuity that guarantees a certain payment every year for the rest of your life. While this is likely to be a payment that is lower than perhaps a good stock market scenario would bring, it gives you peace of mind and leaves you to just manage lifestyle rather than worry about whether a bear market is going to tank your retirement years.
It’s much easier to downsize lifestyle and then simply maintain it based on what you know will be coming in each year than it is to have a lifestyle reduction forced upon you during a stressful time of market turmoil.
Note that this scenario can bring inflation risk depending on the annuity instrument purchased. If your amount is fixed annually, then inflation will essentially eat the purchasing power of that amount over time, and you will be in a situation where your lifestyle will not only need to be maintained but reduced slowly over time as your money buys less and less. Again, this can still be a great situation for people will minimal retirement funds. Just make sure you’re going into it with eyes wide open on the inflation factor.
The limitations of average returns
As we’ve demonstrated in this article, the concept of average market returns is almost meaningless for retirement investors. For younger investors in accumulation mode, average market returns is very relevant. It tells us where our portfolio is likely to get to over a long period of time. But for retirees, average returns does nothing.
If a retiree takes a major hit early during retirement, there is not much consolation in knowing that the stock market will average 7% annual returns over time. His portfolio has already been significantly damaged and he is at risk of running out of money even with a typical snap back bull market after a bear market.
If you’re using a financial advisor that is basing your retirement years around average returns or is producing retirement models around average returns, it likely makes sense to find another advisor.
The better way is to use projections using actual past market history results. This can be done with a tool such as the FireCalc. This tool will show you if you retire with a certain amount of money and plan to withdraw a certain amount each year, what would have happened if you retired during any specific year over the history of the stock market. For example, if you retired in 1928 right before the market crash of 1929, how would your portfolio do? Or if you retired in 2009 right before a ten year bull market? How about then? These types of tools can show you all of these variations then show you how likely you are to run out of money or be completely fine during your retirement based on actual market history. Essentially, you’re seeing how likely your retirement planning is to succeed based on a model of actual sequences of returns that have happened rather than a model of average stock market returns.
Why should young investors care?
So, sequence of returns is of utmost important to retirees and late-stage investors, but what about young investors? Shouldn’t young investors just care about average returns and ignore sequence of returns risk? The answer is a qualified, yes.
Yes, young investors with at least 15 years until retirement do not need to be concerned with sequence of returns risk from a practicality standpoint. Your investment actions should not be dictated at this time by sequence of returns risk. Instead, you should focus on dollar cost averaging and average market returns. This is the focus of accumulation mode investing.
But it’s extremely important to be aware of sequence of returns risk for several reasons. First, understanding this concept in detail and understanding the differences between accumulation portfolios and distribution/retirement portfolios is paramount. Having a firm grasp on these concepts will make you a better investor overall and help you manage your long-term finances well. Additionally, sequence of returns risk is rarely mentioned in financial advice and financial planning especially when compared to volatility risk. By knowing these concepts, you’ll be a much better all around investor and financial planner and be able to properly interview and question professionals you might consider hiring.
Frequently asked questions
How do you manage the sequence of return risk?
You can manage this risk by ensuring a conservative withdrawal rate on your retirement assets, maintaining a cash buffer than can be drawn upon during market turmoil or by utilizing guaranteed fixed income streams such as annuities.
What is sequencing risk in retirement?
Sequencing risk refers to the risk of being hit with a major bear market early during retirement, and because the retiree is drawing on the portfolio, the longevity of the portfolio is severely impacted and the retiree risks running out of money.
What is a bond tent?
The bond tent typically refers to building up a larger allocation of bonds as an investor approaches retirement, then spending down this allocation to bonds during the early years of retirement and thus letting the equities portion grow.