Why Sequence Risk Matters in Retirement

  • Originally published July 26, 2011 , last updated May 27, 2016

Bear markets are inevitable — a fact that surely hasn’t escaped your clients. But what they may not realize is that how much they lose during a market downturn may not be nearly as important as when the loss occurs.

This concept is called Sequence Risk and it says that the timing of losses, namely those losses sustained early in the distribution phase, can have a major impact on a retirement portfolio’s duration. Specifically, losses that occur early on in retirement have a much greater impact than those suffered later on. And the damage from those losses increases exponentially when you are simultaneously depleting your portfolio through income payments.

The attached illustration shows how sequence of returns will affect a portfolio during the both the accumulation and the distribution phase. It shows two portfolios, Portfolio A and Portfolio B, that both get the identical returns, only the order of the returns is reversed. In the accumulation phase, the outcome of each portfolio is unaffected by Sequence Risk. However, you will see that during the Distribution Phase — even though both portfolios get the same overall 8% average return — the portfolio that experiences negative returns in the first three years vastly underperforms the one that has positive returns in the first three years.
 
How to Mitigate the Effects of Sequence Risk
 
You cannot totally eliminate the affects of Sequence Risk because much of it is simply bad luck. Your client may have the misfortune of retiring right before a significant market downturn. Or they may experience losses in the five years right before their retirement — the period known as the Retirement Red Zone.

A bad market cannot be helped, but you can help mitigate the effect is has on your client’s portfolio by helping them fund their retirement with money that is not tied directly to the market and, therefore, has no downside risk. In other words: Annuities.

The topic of Sequence Risk is one you need to be discussing with prospects and clients who are approaching retirement. It’s an excellent way to drive home why it is so important for people to shift their assets from stocks to less volatile savings vehicles like fixed annuities as they approach retirement.
 
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