Sequence of Returns

Sequence of Returns refers to the order in which investment returns occur over time. It becomes especially important during the withdrawal phase of a portfolio (like retirement), as the timing of positive and negative returns can significantly affect how long your money lasts — even if the average return stays the same.

Key Concepts:

1. Accumulation Phase (When You're Saving):

• The sequence of returns does not matter much.
• What matters is the average rate of return over time.
• Whether you get bad returns early or late, your final portfolio value will be about the same.

2. Withdrawal Phase (When You're Retired):

• The sequence of returns matters a lot.
• Bad returns early in retirement, when you are also making withdrawals, can deplete your portfolio faster.
• This is known as sequence of returns risk.

Example:

Let’s say two retirees start with $1 million and withdraw $50,000 annually. Both have an average return of 5% over 30 years, but:

• Retiree A has strong returns early, then weak returns later.
• Retiree B has weak returns early, then strong returns later.

Even though their average return is the same, Retiree B may run out of money much sooner than Retiree A because the early losses plus withdrawals reduce the base too quickly.

Why It Matters:

• Retirees and pension funds must be particularly careful      about sequence risk.
• It’s why safe withdrawal strategies, diversified portfolios, and annuity products  can be useful.
• Mitigation strategies include:
  • Reducing spending in down years.
  • Using a bucket strategy (short-term cash, medium-term bonds, long-term stocks).
  • Building a buffer with guaranteed income (like Social Security or annuities).

*** Here is an example of Sequence of Returns. Two people, both with $500,000 accounts. They each will take $30,000 out each year of retirement. The person on the left retires in 1998 and the other person retires 2 years later, starting in the year 2000.

     On the left, the market starts out great, over 25% in the first year and almost 20% in the second year. But the person on the right retires in the year 2000 and we hit the Tech Bubble! Three straight down years. Within 3 years they have less than 1/2 of the original $500,000 and they run out of money by year 13.

    This is the potential result from the Sequence of Returns. We can't predict the future. We don't know what the next 20-25 years will look like in the market. But can you take the risk of all your money tied up in the market?

    In this scenario, your retirement success is 100% dependent on market performance.

Is that way too much risk for your current season of life?