When building your retirement portfolio, investing in a routine, systematic way can ensure that you purchase assets at random prices over time. So long as the market moves higher in the long run, any temporary declines, or even major corrections, will provide you with the chance to buy assets on sale. The same cannot be said for investors in the distribution phase of life, when market dips—particularly those that occur when account balances are highest—can really derail a retirement plan. The risk posed by the order of your investment returns is commonly known as sequence of return risk.
Sequence risk is perhaps best explained by example: Consider Bob, a 60-year-old nearing retirement, who has accumulated $500,000 in his IRA. Bob plans to withdraw $20,000 from his IRA each year to supplement his other income sources. Assuming a normal level of market growth, Bob is hoping his portfolio can withstand both his annual withdrawals and normal market volatility for 30 years. But what if market conditions cause his portfolio to drop 5% each year for the first 3 years of Bob’s retirement? That, when combined with the annual withdrawals, could quickly drop the value of Bob’s account down to about $371,888, erasing years of progress. This would be a glaring example of sequence of return risk, and the unfortunate timing of the market decline when Bob’s account values are highest create the need to rethink his withdrawal strategy to avoid draining the account too quickly.
Wade Pfau, a professor and noted retirement income expert, did a fascinating study to show just how impactful the order of your investment returns can be. Pfau ran the investment returns of 151 people who hypothetically invested an identical amount of money for 30 years, the only difference being the start date for each investor. Pfau found that the average investor would build a nest egg equal to roughly 10 times their salary, but the individual outcomes ranged from a little less than 3 times salary to more than 27 times salary, simply depending on when that person entered the workforce and started investing.
Pfau’s research shows that sequence risk can create an even bigger problem if retirees use a constant, inflation-adjusted withdrawal strategy. In the study above, the lucky investors who entered the market and later began withdrawing at the right times could have sustained a 10%+ withdrawal rate during retirement, while those who entered and withdrew from the market with more unfortunate timing could only sustain a 1.9% withdrawal rate.
Mitigating sequence risk is particularly tough because nobody has a crystal ball that can indicate when the market is going to drop and by how much. A gut reaction to this concern may be to tone down the risk within your portfolio at the point when your accumulation objective transitions to preservation and distribution. You may not need to do that if your asset base is large enough to withstand an enhanced level of volatility. But if your plan is to heavily rely on portfolio withdrawals during retirement, you might have little choice but to dial down stock risk around the time of retirement.
Another option for some retirees may be to utilize a more dynamic withdrawal strategy in which more money is removed from a portfolio when returns are high than when returns are low. Some people may even choose to skip withdrawals altogether in years when the market produces negative returns. The idea here is to not compound the risks posed by normal market volatility by also taking withdrawals when your account values are lower. Such withdrawals would create a greater obstacle to your portfolio recovering value.
Ultimately, there isn’t a perfect solution to getting around sequence risk because none of us can accurately predict market movement. Fortunately, this issue isn’t as big a concern during the accumulation years, especially the early ones, because those dips provide buying opportunities. However, those of us at or near retirement should take a step back to consider our current asset allocation and whether it remains appropriate given our current age and risk tolerance. Doing this sort of planning may better prepare you for sequence risk and save you some headaches down the road.
 Year 1: $500,000 - $25,000 (5%) - $20,000 = $455,000. Year 2: $455,000 - $22,750 (5%) - $20,000 = $412,250. Year 3: $412,500 - $20,612 (5%) - $20,000 = $371,888.
 Pfau, Wade: “You Can’t Control When You’re Born…” September 20th, 2013: www.retirementresearcher.com