Sequence of Returns Risk

Sequence risk is the impact that high/low sequence of market returns have on asset growth. It is one of the key factors discussed in our blog “Retirement Characteristics” that could profoundly impact retirement planning. Here, we explain the sequence risk using the analysis from Wade Pfau at Retirement Researcher. Consider a scenario in which the working and retirement periods are 30 years each. The sequence risk captures the percentage impact market return has on a particular year in our scenario. All the vertical bars add up to 100%.

The sequence risk during one’s early working years is not so high due to smaller asset sizes. Also, contributions to the nest egg act as a cushion against market volatility. The sequence risk during the latter years are also subdued because of the very little time left in one’s lifespan. The 31^st year, which is the first year in retirement, has the highest sequence risk, followed by the next few years soon after one retires. This is because the nest egg is at its largest at retirement and the constant withdrawal from the nest egg to support retirement further increases the sequence risk.

Pfau provides a market example to illustrate how withdrawals amplify sequence risk by looking deeper into Bengen’s popular 4% withdrawal rule (explained further in our blog “Retirement Rules”). The 4% rate corresponds to the worst-case retirement period (1966-95) in Bengen’s analysis. The actual market return during this 30-year period was 4.2% CAGR. However, the 1966 retirees who withdrew 4% of their nest egg every year as their retirement income only realized an asset growth rate of 1.99% CAGR during this period. This is because, the initial poor market returns could not be overcome by the better than average returns that followed in latter years.

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