Sequence of Returns Risk
Sequence of returns risk arises when the order of investment returns changes how much money a portfolio can accumulate or support in withdrawals. Poor returns early in retirement can shorten the life of a portfolio funding regular spending.
Exam Tip
With contributions or withdrawals, the same returns in a different order can produce different balances. Early losses can be particularly damaging when retirement spending draws on the portfolio.
How the Order of Returns Changes Outcomes
Start with USD 100,000 and withdraw USD 10,000 at each year-end, after applying that year's investment return.
| Return order | End of year 1 after withdrawal | End of year 2 after withdrawal |
|---|---|---|
| −20%, then +25% | USD 70,000 | USD 77,500 |
| +25%, then −20% | USD 115,000 | USD 82,000 |
With no cash flows, the same two returns leave USD 100,000 in either order because 0.80 × 1.25 = 1. With withdrawals, an early loss leaves a smaller balance to participate in the recovery. With contributions, the order can also matter because later returns apply to money added along the way.
Ways to Manage the Risk
- Cash reserve: Cover some spending from a reserve when markets fall.
- Flexible withdrawals: Reduce portfolio withdrawals when the balance drops.
- Lifetime income: Use guaranteed lifetime income to cover part of spending, subject to the contract and insurer.
- Earned income: Reduce portfolio withdrawals with part-time income.
The years around retirement can be especially sensitive because the portfolio is often large and withdrawals are about to begin or have just begun. A simulation with varying return paths can illustrate the risk. A constant-return projection cannot show the effect of changing their order.
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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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