Sequence risk refers to the chance of running out of money in retirement due to a period of bad returns. While it can occur, Javier Estrada of Spain’s IESE Business School argues that sequence risk is commonly over-exaggerated, leading retirees to pursue overly conservative asset allocation strategies or reduce their standard of living.
by AAII Staff | December 2020
Sequence risk refers to the chance of running out of money in retirement due to a period of bad returns. While it can occur, Javier Estrada of Spain’s IESE Business School argues that sequence risk is commonly over-exaggerated, leading retirees to pursue overly conservative asset allocation strategies or reduce their standard of living.
He defined the risk as “A sequence of low (typically large and negative) returns, early in (typically in the first half of) the retirement period, that leads to portfolio failure unless the withdrawal strategy is reconsidered (typically implying a substantial decrease in withdrawals).” To determine how significant this risk is, Estrada used S&P 500 index annual returns for 30-year retirement periods between 1900 and 2019. The initial portfolio was set at $1,000 and an initial withdrawal rate of 4% was used.
The analysis led Estrada to conclude that “what leads to failure is the combination of early low returns and inflexible withdrawals. Portfolio depletion can obviously be avoided if the retiree lowers his withdrawals enough to make it through the end of his retirement.”
One way to assess sequence risk is to use actual returns. This method compares annualized returns over the first three, five or 10 years of retirement to the averages of all the retirement periods considered. The lower the annualized returns relative to the averages, the more likely a retiree was a victim of sequence risk.
Another is to use a forecast returns approach. Estrada explains, “If an early sequence of low returns leads a retiree to lower his future inflation-adjusted withdrawals so that they remain sustainable, the next issue to be addressed is by how much.” A retiree has been a victim of sequence risk if the decline in withdrawals is larger than 10% to 15%. He added, “the advantage of this framework is that it enables a retiree to monitor in real time the sustainability of his withdrawal strategy and to dynamically introduce changes that lower, and in the limit eliminate, the probability of portfolio depletion.”
Source: “Sequence Risk: Is It Really a Big Deal?,” by Javier Estrada; IESE Business School, Barcelona, Spain; September 2020.
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Portfolio Strategies
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