What is Sequence of Return Risk? How to Minimize that Risk

Sequence of return risk is an often overlooked part of retirement, regardless of whether we are discussing a traditional retirement or early financial independence.  Long term growth rates of diversified properly allocated investments only tell a part of the story.  It is the sequence of those returns that tell the rest.

What is Sequence of Return Risk?

According to investopedia sequence of return risk is,

The risk of receiving lower or negative returns early in a period when withdrawals are made from the underlying investments. The order or the sequence of investment returns is a primary concern for those individuals who are retired and living off the income and capital of their investments. 

I think an example provides the best way to understand the concept.

Comparing Sequence of Return Risk Scenario

Just for example purposes I am going to use a person who retired in 2000 with a nest egg of a $1,000,000 who subscribed to the 4% withdrawal rule indexed for inflation.  The historical return was taken from wikipedia and includes dividends.  The withdrawal was done at the end of the year.

BOY Balance Historical Return Withdrawal EOY
2000 $1,000,000 -9.10% $40,000 $869,000
2001 $869,000 -11.89% $41,200 $724,476
2002 $724,476 -22.10% $42,436 $521,931
2003 $521,931 28.68% $43,709 $627,911
2004 $627,911 10.88% $45,020 $651,208
2005 $651,208 4.91% $46,371 $636,811
2006 $636,811 15.79% $47,762 $689,602
2007 $689,602 5.49% $49,195 $678,266
2008 $678,266 -37% $50,671 $376,637
2009 $376,637 26.46% $52,191 $424,104
2010 $424,104 15.06% $53,757 $434,217
2011 $434,217 2.11% $55,369 $388,010
2012 $388,010 16.00% $57,030 $393,061
2013 $393,061 32.39% $58,741 $461,632
AVERAGE RETURN: 5.55%

 

However, if we were to take the exact same returns but reverse them we will have a different picture:

BOY Balance Historical Return Withdrawal EOY
2000 $1,000,000 32.39% $40,000 $1,283,900
2001 $1,283,900 16.00% $41,200 $1,448,124
2002 $1,448,124 2.11% $42,436 $1,436,243
2003 $1,436,243 15.06% $43,709 $1,608,833
2004 $1,608,833 26.46% $45,020 $1,989,509
2005 $1,989,509 -37.00% $46,371 $1,207,020
2006 $1,207,020 5.49% $47,762 $1,225,523
2007 $1,225,523 15.79% $49,195 $1,369,838
2008 $1,369,838 4.91% $50,671 $1,386,427
2009 $1,386,427 10.88% $52,191 $1,485,079
2010 $1,485,079 28.68% $53,757 $1,857,243
2011 $1,857,243 -22.10% $55,369 $1,391,423
2012 $1,391,423 -11.89% $57,030 $1,168,952
2013 $1,168,952 -9.10% $58,741 $1,003,836
AVERAGE RETURN: 5.55%

 

More than double then the previous sequence.  But since no one reading this blog could possibly change the order of returns why does the concept matter?

How to Minimize Sequence of Return Risk

As alluded to it is unavoidable, but there are financial moves which could be made that would put you in a better position.  For example what if we didn’t withdraw anything from the nest egg in 3 of the worst years (on the base historical model which coincidentally is the worse situation):

BOY Balance Historical Return Withdrawal EOY
2000 $1,000,000 -9.10% $40,000 $869,000
2001 $869,000 -11.89% $0 $765,676
2002 $765,676 -22.10% $0 $596,462
2003 $596,462 28.68% $43,709 $723,818
2004 $723,818 10.88% $45,020 $757,549
2005 $757,549 4.91% $46,371 $748,374
2006 $748,374 15.79% $47,762 $818,780
2007 $818,780 5.49% $49,195 $814,536
2008 $814,536 -37% $0 $513,158
2009 $513,158 26.46% $52,191 $596,748
2010 $596,748 15.06% $53,757 $632,862
2011 $632,862 2.11% $55,369 $590,846
2012 $590,846 16.00% $57,031 $628,350
2013 $628,350 32.39% $58,741 $773,132

 

By eliminating just 3 of the bear years we increased our remaining nest egg by nearly 40% (or nearly 30% if we add back in the $134K back into the equation).  What type of assets would provide the ability to limit those terrible bear years? Obviously, not everyone’s situation is the same, but some very basic moves would include:

  • Using the cash in a whole life policy
  • A penalty free withdrawal from an annuity
  • Working part time until the bear market subsides
  • Reverse mortgage (although I think this would only be brought up in a very extreme situation)
  • A cheap HELOC
  • Using part of an emergency cash reserve

Any option is going to require some type of planning/sacrifice (i.e. you would have to actually own a whole life insurance policy or annuity, or you would have to sacrifice your retirement for a paycheck), but I think the most desirable situations would be surrounding the using of assets differently rather than taking on debt.  For example, it makes more sense to me for someone to use their whole life insurance policy a little bit differently than it would be to take on a debt like a HELOC, however, that may be different for someone else.

4 Responses to What is Sequence of Return Risk? How to Minimize that Risk

  1. Here’s an interesting point related to sequence risk. For someone who just retired and will now be drawing down their investments, a major downturn in the market of those assets (presumably equities) is the worst thing that could financially happen to them. However, for someone fresh out of college with their entire work career ahead of them, that major downturn is actually the best thing that could financially happen to them. This is because they will be able to buy low early in the compounding timeframe.

    So for one person, it’s an adverse event. For another, it’s a desirable event. It seems like conceptually there’s got to be some possible insurance idea here…

  2. Excellent example! This is why I do not trust the 4% rule and would rather only spend dividends/interest leaving the principle untouched. A stream of dividends/interest has its own risks, but I think a well diversified portfolio (40-50 positions) of very high quality companies would help here. Especially in regards to inflation. Nothing is guaranteed unfortunately.

    • Couldn’t agree more! Imagine a time when you and I don’t have to care about the ups and downs of the market? Your dividend gets paid from a company that has been doing it for 20, 30 or 50 years (possibly inflation adjusted)…No need to sell principal, Just living off the dividend!

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