Sequence of Returns Risk
Sequence of returns risk is the danger that the timing of poor investment returns, particularly in the early years of retirement withdrawals, can permanently deplete a portfolio even if average long-term returns are adequate.
Exam Tip
Sequence risk = timing of returns matters ONLY during withdrawals. Early retirement years are most vulnerable. Same average return can produce different outcomes. Monte Carlo captures this; straight-line does not.
What is Sequence of Returns Risk?
Sequence of returns risk (also called sequence risk) occurs when retirees experience poor market returns early in retirement while simultaneously withdrawing funds. Unlike the accumulation phase where the order of returns does not matter, the withdrawal phase makes the sequence critical to portfolio survival.
Why Sequence Matters in Retirement
| Scenario | Average Return | Early Returns | Outcome |
|---|---|---|---|
| Good Sequence | 7% | Positive first 5 years | Portfolio survives 30+ years |
| Bad Sequence | 7% | Negative first 5 years | Portfolio depleted in 18-22 years |
Both scenarios have the SAME average return, but vastly different outcomes when withdrawals are occurring.
Mitigation Strategies
| Strategy | How It Helps |
|---|---|
| Cash Reserve (Bucket Strategy) | 1-3 years of expenses in cash/bonds to avoid selling in downturns |
| Flexible Withdrawal Rate | Reduce spending in bad markets (guardrails approach) |
| Bond Tent | Increase bond allocation at retirement, gradually shift back to stocks |
| Annuitization | Guaranteed income floor reduces portfolio withdrawals |
| Part-Time Work | Reduces or eliminates withdrawals in early years |
The Retirement Risk Zone
The 5 years before and 5 years after retirement are the most vulnerable period. Poor returns during this window have the greatest impact on long-term portfolio sustainability.
Exam Alert
Sequence risk only matters when WITHDRAWALS are occurring (retirement). During accumulation, order of returns is irrelevant. The first 5-10 years of retirement are the most critical. Monte Carlo simulation captures this risk; straight-line projections do NOT. Mitigation: bucket strategy, flexible withdrawals, bond tent, annuities.
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Related Terms
Asset Allocation
Asset allocation is an investment strategy that divides a portfolio among different asset classes (stocks, bonds, cash) based on an investor's goals, risk tolerance, and time horizon to optimize risk-adjusted returns.
Monte Carlo Analysis
Monte Carlo Analysis is a retirement planning technique that uses computer simulations to model thousands of possible market scenarios, generating a probability of success (typically 0-99%) for a financial plan rather than relying on a single assumed rate of return.
Rebalancing
Rebalancing is the process of periodically adjusting a portfolio back to its target asset allocation by buying underweighted assets and selling overweighted ones. This risk management strategy can be calendar-based (e.g., quarterly or annually) or threshold-based (when allocations drift beyond set limits).
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