Sequence Risk: Meaning, Retirement, Protection

What Is Sequence Risk?

Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor. This can have a significant impact on a retiree who depends on the income from a lifetime of investing and is no longer contributing new capital that could offset losses. Sequence risk is also called sequence-of-returns risk.

Understanding Sequence Risk

Sequence risk revolves around the timing dynamics in investing. It’s usually most important during the initial stages of retirement or when withdrawing funds from an investment portfolio. The sequential order of investment returns can have a significant impact on the overall effectiveness of an investment strategy.

Simply put, if a portfolio experiences negative returns right when withdrawals are happening, especially in retirement, it can have a lasting and adverse effect on the portfolio’s value. This is because there are fewer assets left to benefit from potential market recoveries in subsequent periods. Conversely, positive returns in the early stages of retirement can positively influence the longevity of a portfolio, especially if the early portfolio balance is high.

How Sequence Risk Happens

At some point, you retire. You are no longer contributing new money but you are withdrawing money on a regular basis. If you happen to be in a bull market, your withdrawals will be offset at least in part by new gains.

If a bear market is in effect for months or years, each of your withdrawals is taking a bite out of the balance and is not being offset by new deposits. You’re taking the same amount of cash out of an account that is steadily shrinking in size.

Sequence risk is, for the most part, a matter of luck. If you retire in a bull market, your account may grow large enough to sustain a subsequent downturn. If you retire in a bear market, your account balance may never recover. This is not under the investor’s control, but there are opportunities to limit the downside risks.  

Sequence Risks and Asset Classes

Sequence risk can impact different asset classes in various ways, and investors should be aware that it may be better or worse to treat certain assets in a certain way when they retire. Here’s a breakdown of how different asset classes may be affected:

• Equities: Equities are generally more volatile than other asset classes. In the early years of retirement, a downturn in the stock market can significantly impact the value of a portfolio, especially if withdrawals are being made. This can amplify sequence risk.
• Fixed-Income: Bonds are sensitive to changes in interest rates, and rising interest rates can lead to capital losses in bond portfolios. If interest rates rise during the early years of retirement, it can negatively impact the value of bond holdings, also amplifying sequence risk. Note that bonds typically don’t have as much volatility as equities, so retirees may prefer holding them to preserve their portfolio value when they begin withdrawing.
• Cash and Cash Equivalents: While cash provides stability, it typically generates lower returns. In a low-interest-rate environment, relying too heavily on cash equivalents may mean your portfolio doesn’t earn anything. There is a little sequence risk here in that your portfolio may be eroding purchasing power over time.
• Real Estate: Real estate values can be influenced by many different economic conditions. If there’s a downturn in the real estate market during the early years of retirement, it may also further perpetuate the impact of sequence risk.
• Other Alternative Investments: Alternative investments, such as hedge funds, cryptocurrency, commodities, or private equity, may offer diversification benefits. However, they may also be more volatile based on how the market is doing. These asset classes may leave investors more exposed to portfolio losses (with the chance of higher portfolio profit), thus escalating sequence risk as well.

Example of Sequence Risk

Let’s consider the hypothetical case of Sarah, a retiree who begins her retirement with a $1 million investment portfolio. Sarah plans to withdraw $40,000 annually for living expenses, adjusting for inflation each year. She has a well-diversified portfolio consisting of 60% stocks and 40% bonds.

In Scenario A, the early years of Sarah’s retirement experience positive investment returns. The stock market performs well, and her portfolio grows by 8% in the first two years. As a result, her portfolio balance after the second year is approximately $1.166 million.

However, in Scenario B, the sequence of returns is unfavorable. The first two years of Sarah’s retirement see negative investment returns, with the portfolio declining by 10% each year. After the second year, her portfolio balance drops to around $810,000.

Even though Sarah will be withdrawing $40,000 each year no matter what, there is sequence risk due to the amount she will be reducing her overall portfolio. In Scenario A, where positive returns occur early in retirement, Sarah’s portfolio experiences growth, and she withdraws $40,000 annually. In contrast, in Scenario B, the negative returns in the early years, coupled with annual withdrawals, lead to a more significant reduction in the portfolio balance. For Portfolio A, she would still have over $1,000,000 after the first two years; for Portfolio B, she would at less than $750,000.

This illustrates how sequence risk can have a lasting impact on the sustainability of a retirement portfolio, as early losses can deplete the portfolio more rapidly. This is because Sarah’s annual withdrawal amount ($40,000) represents a larger proportion of the smaller portfolio that experienced losses.

Strategies to Mitigate Sequence Risk

Protecting against sequence risk means anticipating a worst-case scenario. Don’t assume that a bull market will reign through your retirement.

• Consider working as late as you can in order to contribute more to your retirement account, particularly in your peak earning years.
• Keep saving and investing even after you retire. If you’re past age 70½, you can’t use a traditional IRA but you can contribute to a Roth IRA or, for that matter, open a personal investment account.
• Diversify your portfolio. You can protect your portfolio by investing in high-quality corporate and government bonds.
• Consider adjusting asset allocation based on market conditions and your proximity to retirement. A more conservative allocation may be appropriate if you foresee higher sequence risk based on your short-term withdrawal needs.
• Establish an emergency fund separate from your investment portfolio. Having a cash reserve can provide a buffer for living expenses during periods of market downturns, reducing the need to sell investments.
• Conduct regular reviews of your investment portfolio and retirement plan. Periodic assessments can help you make necessary adjustments based on changing market conditions or personal circumstances.

The Bottom Line

Sequence risk highlights the vulnerability of investment portfolios to poor performance during specific periods, particularly in the early years of retirement. The order in which investment returns occur can significantly impact the long-term sustainability of a portfolio. This means you may end up facing more challenges when trying to pay for expenses during retirement.