Return sequence, or return sequencing, is a phrase used to describe the year-over-year investment returns experienced by a portfolio for a select period, such as an annuity accumulation period, the five-year period prior to retirement or the 10-year period following retirement.
Why Is Return Sequencing Important?
Return sequencing matters because the order in which returns occur, when coupled with ongoing withdrawals, can have a significant impact on the value of an investment portfolio. This exposure is known as sequence of returns risk.
It is a pertinent risk for any investor, but it is a particularly significant threat to a retiree, especially one who depends on their portfolio to maintain their standard of living. This individual may have little to no flexibility, which makes the resiliency of their portfolio a paramount concern. Ideally, they need the returns generated by it to overshadow their expense withdrawals. At a minimum, they need the returns to stave off a complete drawdown until death.
Unfortunately, this doesn’t always work, especially when an adverse sequence of returns puts downward pressure on asset values. The situation can be exacerbated when simultaneous inflationary pressure significantly increases the individual’s cost of living.
For this reason, a sound retirement plan will assess a full range of potential outcomes, utilizing an array of dynamic variables, including spending levels, inflation, expected returns and the sequencing of returns. The variables and their interplay can be modeled hundreds or thousands of times via a statistical projection tool known as the Monte Carlo simulation. The output provides a retiree with visibility into the full spectrum of potential outcomes and their probabilities, which helps convey the impact of uncertainty and risk on a retirement plan.
Mapping Out Your Retirement: Are You on Track?
Example of Sequence of Returns Risk
As noted above, sequence of returns risk is most relevant for a retiree, especially an early-stage retiree. For a retiree, persistently negative portfolio returns, when paired with ongoing withdrawals, can have a devastating effect on portfolio value. In many instances, the loss can be irrecoverable, resulting in the realization of longevity risk, which is the risk of outliving your savings.
To illustrate, let’s look at a numerical example.
Below, we have two scenarios, outlining potential ending portfolio values for an individual over the first 10 years of retirement. Each simplistically assumes a beginning value of $1 million and a $40,000 living expense drawdown at the end of year one, which grows at a 2 percent annual rate of inflation, thereafter.
Scenario A
| Year | Portfolio Value | EOY Withdrawal | Net Return |
|---|---|---|---|
| 0 | $1,00,000 | ||
| 1 | $1,140,000 | $40,000 | 18.0% |
| 2 | $1,235,200 | $41,600 | 12.0% |
| 3 | $1,303,104 | $43,264 | 9.0% |
| 4 | $1,323,265 | $44,995 | 5.0% |
| 5 | $1,250,005 | $46,794 | -2.0% |
| 6 | $1,376,340 | $48,666 | 14.0% |
| 7 | $1,504,651 | $50,613 | 13.0% |
| 8 | $1,421,921 | $52,637 | -2.0% |
| 9 | $1,253,424 | $54,743 | -8.0% |
| 10 | $1,021,012 | $56,932 | -14.0% |
| Average Geometric Return | > > | > > | 4.0% |
Scenario B
| Year | Portfolio Value | EOY Withdrawal | Net Return |
|---|---|---|---|
| 0 | $1,000,000 | ||
| 1 | $820,000 | $40,000 | -14.0% |
| 2 | $712,800 | $41,600 | -8.0% |
| 3 | $655,280 | $43,264 | -2.0% |
| 4 | $695,472 | $44,995 | 13.0% |
| 5 | $746,044 | $46,794 | 14.0% |
| 6 | $682,457 | $48,666 | -2.0% |
| 7 | $665,967 | $50,613 | 5.0% |
| 8 | $673,266 | $52,637 | 9.0% |
| 9 | $699,316 | $54,743 | 12.0% |
| 10 | $786,260 | $56,932 | 18.0% |
| Average Geometric Return | > > | > > | 4.0% |
Despite identical beginning values, drawdown patterns, annual inflation and annualized geometric returns over the 10-year period, the scenarios reflect dramatically different ending portfolio values. Scenario A ends more than $250,000 higher than Scenario B ($1,021,012 vs. $768,260), a 33 percent difference.
This is a prime example of sequence of returns risk. You see, the only assumption that differs between Scenario A and Scenario B is the order of returns. They have been reversed, with A suffering a relatively adverse string of negative returns at the end of the time horizon and B suffering them at the very beginning.
Clearly, timing can have a powerful and very significant effect on wealth. While asset returns and their sequencing cannot be controlled, there are some things you can do to mitigate their impact. Let’s explore a few.
How to Protect Against Sequence of Returns Risk
Measures to protect against sequence of returns risk include diversifying your portfolio, maintaining a flexible budget and increasing your savings.
Strive to Bolster Your Savings
For starters, consider delaying retirement for a few years, if you can comfortably do so. This will allow you to accumulate a larger nest egg, which could prove invaluable during volatile times. As a complement to working longer, explore the possibility of generating incremental post-retirement income via a part-time job or a passive activity.
Maintain a Flexible Budget
Another way to ensure the longevity of your savings is to maintain a flexible budget. Here, a dynamic, market-aware approach to spending is key. When returns are negative and/or inflation is running higher than expected, you need to reduce annual spending to preserve your portfolio. Conversely, when returns are high and/or inflation is lower than expected, you can loosen the purse strings a bit.
This dynamic approach can be implemented in a variety of ways. Many well-known methods reflect a rules-based scheme that adjusts upward or downward from a baseline annual level, such as 4 percent of portfolio value.
William Bengen established the foundational work for these models in his 1994 paper entitled “Determining Withdrawal Rates Using Historical Data.” In the paper, Bengen asserts “Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe.”
Construct a Diversified Portfolio
A diversified investment portfolio is the foundation of any retirement plan. The composition of your portfolio should reflect your preference for the trade-off between risk and return, along with your investment objectives, risk tolerance, cash flow constraint and tax situation.
In constructing your portfolio, endeavor to achieve an appropriate level of diversification across and within assets classes. This generally means a fairly large allocation to growth-oriented assets, like publicly traded stocks, and a meaningful allocation to more stable, income-oriented assets, like investment grade bonds.
Regardless of the allocations, over time, the values of some assets may increase, while those of others will decrease. A diversified portfolio capitalizes on the less than perfect correlations across assets and tamps down volatility, thereby facilitating a more stabilized return pattern. Over a long period of time, this is likely to offer a more desirable outcome to a less diversified approach.
Consider Purchasing an Annuity
In some instances, a well-constructed portfolio can be complemented by the purchase of an annuity. The lifetime income streams provided by many of these products can offer added protection against adverse return sequencing and longevity risk, while offering some upside potential.
Key Takeaways
A return sequence is a phrase that describes the year-over-year returns achieved by an investment portfolio for a select period. While a geometric return computation smooths the annualized sequence, the actual order of returns can be highly significant, especially for a retiree with ongoing withdrawals.
In this situation, exposure to an adverse series of returns is known as sequence of returns risk. Essentially, this refers to the possibility of running down a retirement portfolio prior to death, a grave risk that can be exacerbated by inflationary-induced cost of living increases.
Fortunately, there are a few mitigating measures you can take. These include striving to bolster your savings — before and after retirement — maintaining a flexible budget and constructing a diversified investment portfolio, which, in some instances, can be complemented by the purchase of an annuity.
