Foster Group

Markets have recovered significantly from the “bottom” of March 9, 2009, and there’s a tendency to feel the worst is behind us and better days lie ahead.  While that may be true, we’ll undoubtedly experience declining markets again.  Understanding your exposure to these negative time periods is important and often misunderstood.  The term given to this is “Sequence Risk,” which Investopedia.com defines as:

 “The risk of receiving lower or negative returns early in a period when withdrawals are made from the underlying investments.”

There has been a marked increase in the amount of attention given to the idea of “Sequence Risk” since the markets of late Q4 2007 through Q1 2009.  This idea focuses on the mathematical reality that in retirement, the sustainability of your portfolio can be dramatically affected by the order in which investment returns are experienced.   To help explain this, consider the following:

Scenario #1 : You enter retirement at the beginning of 1973 with an investment portfolio of $1,000,000 (for those of you old enough to remember, this was a frightening time to be an investor - equity returns over the next two years were down over 40%.)  Your living expenses require a monthly withdrawal of $4,000 from your portfolio, an annual withdrawal rate of 4.8% based on your total portfolio value.  This withdrawal will increase at the rate of inflation and continue for the next ten years.

Scenario #2 : Identical to Scenario #1, except the sequence, or order, of your monthly investment returns over the ten-year period are reversed from Scenario #1.

The end result of each scenario is as follows:

Scenario #1 leaves you with $1,850,094 at the end of the ten years.  That doesn’t sound too bad, but because of inflation you are now withdrawing over $9,000 a month which has actually increased your annual withdrawal rate to 5.9%.  Said another way, while your assets have increased in absolute dollar terms, your purchasing power has declined by almost 20%, as compared to 1973 dollars.

In Scenario #2, you ended 1982 with $2,468,517.  Your annual withdrawal rate decreased to 4.4%.  In this scenario, your purchasing power actually increased by almost 8%.   

The only difference in these scenarios is the experienced sequence of returns. In Scenario #1, investment return for the first two years was -18.72% and -25.19%, respectively; your withdrawals depleted principal right out of the gate. Conversely, scenario 2 returns were much more favorable; 32.52% and 17.72% in the first two years, more than covering the withdrawals and adding to the value of the portfolio.

To be clear, sequence risk only matters if cash flows occur in the portfolio. If there are no cash flows to or from the portfolio, the sequence of returns will not change the ending value. To illustrate this point, consider the following:

Scenario #3 : You have accumulated $1,000,000 at the beginning of 1973. No contributions or withdrawals will be made for the next ten years.

Scenario #4 : Identical to scenario 3, except that the sequence of your monthly investment returns over the ten-year period are reversed from Scenario #3.

The following chart illustrates the value of your portfolio over this ten year period. While the portfolio values vary greatly along the way, they end at exactly the same point.

As markets have recovered nicely and investors are becoming more confident, now may be a perfect time to consider what you can do to protect against sequence risk. Stay tuned . . . this will be the topic of my next piece.