What is Sequence Risk
Sequence risk is also called sequence-of-returns risk. It becomes a danger as an individual takes withdrawals from a fund's underlying investments. The order or the sequence of annual investment returns is a primary concern for retirees who are living off the income and capital of their investments.
BREAKING DOWN Sequence Risk
The danger comes when an investor receives lower or negative returns due to withdrawals made from their investment. Long-term average returns and the timing of taking those returns impact financial wealth.
Financial outcomes can be dramatically different depending on when and how a person begins their retirement days. Issues like the state of the market and if it is a bull market or a bear market are not under the control of the investor. However, investors do have some opportunities to limit their downside risk.
Protecting Against Sequence Risk
Investors have a range of options for protecting retirement assets against sequence risk including working longer and putting off retirement and planning with a worst-case-scenario regarding rates of return. Continuing to make contributions to the retirement fund helps to offset losses during market downturns and provide capital for continuing growth. Investors may diversify their portfolio away from higher risk stocks, which can see considerable fluctuations in value based on the state of the market.
Why Sequence Risk Matters
The sequence of returns may significantly impact the income available during retirement. Two retirees with identical wealth can have entirely different financial outcomes, depending on the state of the economy when they start retirement, even if the long-term market averages are the same.
For example, a person entering retirement at the bottom of a bear market will see the prices of the holdings in their portfolio rise when the market recovers. More crucially, however, that retiree will also see a reduction in the overall return of that portfolio because of how much had to be withdrawn in early retirement when prices were down. Plus, this retiree is essentially withdrawing funds as his or her portfolio looses value. Consequently, that retiree would have less shares of equities which can benefit from positive returns down the road.
By contrast, someone who retires when stock prices are high – letting him or her take early withdrawals of fewer equities because they are worth more – will likely have a higher overall portfolio return than the bear market retiree earns. This is because the bull market retiree has more equities left in that portfolio which can allow this retiree to continue earning returns later in retirement, particularly during a period of strong market returns