Sequence-of-returns risk
Sequence-of-returns risk is the effect of the order of investment returns on a portfolio that fixed-dollar (or inflation-adjusted dollar) withdrawals are taken from. With such withdrawals coming out, the ending balance depends on the order in which the returns arrive: the same returns, with the losses coming later, leave more.
What is sequence-of-returns risk?
With nothing added or taken out, order makes no difference. A portfolio that falls 20%, then gains 10%, then gains 30% ends at the same balance as one that has those three years in reverse, because the growth factors multiply and multiplication gives the same product in any order.
Fixed-dollar withdrawals break that symmetry. When the withdrawal is a set dollar amount, after a loss it takes a larger share of what is left, and the gains that follow compound on a smaller balance. The same withdrawal after a gain takes a smaller share. A withdrawal set as a fixed percentage of the balance does not break it: the order of returns then leaves the ending balance unchanged.
It is a different thing from a low average return. Two retirements can earn the same returns on average, in a different order, and end with different balances.
How sequence-of-returns risk works, with numbers
Two retirees each start with $1,000,000 and take out $50,000 at the end of every year for three years. Both portfolios see the same three yearly returns in reverse order: one gets a 20% loss, a 10% gain and a 30% gain; the other gets a 30% gain, a 10% gain and a 20% loss.
Loss first: $1,000,000 falls to $800,000, and after the withdrawal holds $750,000. The 10% gain takes it to $825,000, then $775,000. The 30% gain takes it to $1,007,500, then $957,500.
Loss last: $1,000,000 grows to $1,300,000, then $1,250,000 after the withdrawal. The 10% gain takes it to $1,375,000, then $1,325,000. The 20% loss takes it to $1,060,000, then $1,010,000. With no withdrawals, both orders would have ended at $1,144,000. Taking 5% of the balance at each year-end instead of $50,000, both orders end at $980,837.
- Loss last, after year three
- $1,010,000
- Loss first, after year three
- − $957,500
- Difference from the order alone
- $52,500
Why sequence-of-returns risk matters
A plan that assumes one average return every year gives every order the same result, so the order of returns cannot show up in it. Varying the returns year by year, as a Monte Carlo simulation does, lets a plan's outcome differ with the order.
Sequence-of-returns risk in Taiga Finance
The Taiga Finance Retirement savings planner simulates every plan it solves. Its “Chance money lasts” figure is the share of simulated return sequences in which the money lasted to the plan's end; opened, it lists the “Real return” and “Return spread” the paths drew from, the number of “Simulated return sequences” and the “Sequences that never ran out”.
The balance chart shades the band between the 10th and 90th percentiles of simulated paths as the “Simulated range”, shown or hidden by a chip in the chart header. The projection itself runs at one expected real return every year; each simulated path re-runs the plan under its own randomized yearly returns around that return.
Scenarios & Reports →Key takeaways: Sequence-of-returns risk
- Sequence-of-returns risk is the effect of the order of returns on a portfolio that fixed-dollar withdrawals come out of.
- Without withdrawals or contributions, the same returns in any order give the same ending balance.
- With fixed-dollar withdrawals, the same three returns in reverse order end differently: $957,500 with the loss first against $1,010,000 with it last, in the example.
- A projection at one constant return cannot show it; year-by-year varied returns can.
Questions about Sequence-of-returns risk
What is sequence-of-returns risk?
The effect of the order of returns on a portfolio that fixed-dollar withdrawals are taken from. The same returns in a different order leave a different balance, and losses early in retirement leave less than the same losses later.
Why does the order of market returns matter in retirement?
When withdrawals are fixed dollar amounts, after a loss a withdrawal takes a bigger share of what is left, and later gains compound on less. In the example, the same three returns in reverse order, with the 20% loss first instead of last, leave $52,500 less after three years.
Does order matter if nothing is withdrawn?
No. With no withdrawals or contributions, the growth factors multiply to the same total in any order: a 20% loss, a 10% gain and a 30% gain turn $1,000,000 into $1,144,000 whichever comes first.
Does Taiga Finance simulate varied market returns?
Yes, on every solve. The Retirement savings planner's Chance money lasts figure is the share of simulated return sequences in which the money lasted to the plan's end, with the count of sequences run and the count that never ran out behind it, and the balance chart shades the 10th to 90th percentiles of the paths as a Simulated range.