Week 25 Day 3: Sequence of Returns Risk: Timing Matters in Retirement

Imagine two retirees, both earning 7% average over 30 years. Retiree A gets good returns first, then bad returns later. Retiree B gets bad returns first, then good returns later. Same average. But Retiree A ends with $2 million while Retiree B ends with $200,000. The early years matter enormously when you are withdrawing money.

Sequence risk example: Both start with $1,000,000, withdraw $40,000/year. Retiree A: gains 15% each year for years 1-5, then loses 10% each year for years 6-10, then gains 7% for years 11-30. Retiree B: loses 10% each year for years 1-5, then gains 15% each year for years 6-10, then gains 7% for years 11-30. Both experience the same average return over 30 years. Retiree A ends with approximately $2.1 million. Retiree B ends with approximately $380,000. The difference: Retiree B sold shares at depressed prices early on, permanently reducing the portfolio's compounding base. Mitigation strategies: (1) Cash buffer: hold 1-2 years of expenses in cash/money market to avoid selling stocks during a downturn. (2) Bond tent: increase bond allocation to 40-50% at retirement (reducing equity exposure during the danger zone), then gradually shift back to 70% stocks over 5-10 years. (3) Flexible spending: reduce withdrawals by 10-20% during down markets. (4) Part-time work: even modest income ($10,000-20,000/year) in the first few years dramatically reduces sequence risk.

Sequence-of-returns risk is formally described by the decomposition of terminal portfolio value into the interaction of returns and cash flows. For an accumulating investor (adding money), sequence risk is negligible because low returns early mean cheaper shares. For a decumulating investor (withdrawing money), the portfolio experiences the mathematical opposite: early losses combined with withdrawals create a compounding deficit. Kitces and Pfau (2015) developed the 'rising equity glide path' concept: starting retirement with 30-40% equities and gradually increasing to 60-70% over 10-15 years actually produces better outcomes than a static allocation or a declining equity path. This is counterintuitive but works because: (1) the low equity allocation during early retirement reduces the magnitude of sequence risk, and (2) the increasing equity allocation allows the portfolio to participate fully in the eventual recovery. The mathematical proof: the variance of terminal wealth is minimized when the portfolio bears the most market risk when it is largest (later in retirement) and the least risk when it is most vulnerable (early in retirement). Blanchett (2007) and Estrada (2020) confirmed the rising equity glide path's superiority across international markets. Implementation: Target Date Retirement 'through' funds (as opposed to 'to' funds) approximate this strategy by continuing to adjust allocation after the target date.