The Hidden Peril in Sequence of Returns Risk
March 10, 2015
by Wade Pfau
Should retirees place greater faith in stocks’ ability to outperform bonds over reasonable holding periods or in insurance companies and bond issuers’ ability to meet their contractual guarantees? Your position on this fundamental question will determine how you choose to build retirement income strategies for your clients.
Instead of taking a side in this debate, I will illustrate how sequence of returns risk can derail a cohort of retirees. Indeed, that can happen without an economic catastrophe wiping out large financial institutions.
You may believe that any situation where stocks underperform bonds would make it impossible for contractual guarantees to be met. As I will explain, that belief is not fully justified.
The relevance of risk pooling
In contrast with defined-contribution pensions, a defined-benefit pension provides benefits more closely aligned with the amount of spending one could support given appropriate investment return and mortality assumptions. This is possible because the pension manager can pool two types of risks that individuals cannot pool on their own. The first of these is longevity risk. This risk is less relevant for today’s discussion, but it reflects the idea that the pension manager can make payments to participants assuming they will live to their life expectancy. Those who die earlier will subsidize the payments to those who live longer.
The more relevant issue is that investment risks can be pooled across different cohorts of individuals who work and retire at different points in time. When individuals manage their own retirement investments, some will experience good sequences that would allow them to spend at a much greater rate than the defined-benefit pension could offer. But others will not be as fortunate; the sequence of returns they experience will lead to a lower level of sustainable income than the defined-benefit pension could have provided. The pension is able to pool these investment risks, giving everyone the same average benefit for the same contributions, by sharing this market risk across cohorts.
Some would have been better off on their own, while others would have been worse off. But things work out on average.
Investment risk and sequence risk
Retirees face market risk, which concerns how market volatility causes average investment returns to vary over time. Sequence of returns risk adds to the uncertainty related to overall investment returns. The financial market returns experienced near one’s retirement date matter a great deal more than most people realize. Even with the same average returns over a long period of time, retiring at the start of a bear market is very dangerous; wealth can be depleted quite rapidly as withdrawals are made from a diminishing portfolio and little may be left to benefit from a subsequent market recovery.
Sequence of returns risk relates to the heightened vulnerability individuals face regarding the realized investment portfolio returns in the years around their retirement date. Though this risk is related to general investment risk and market volatility, it differs from general investment risk. The average market return over a 30-year period could be quite generous. But if negative returns are experienced when someone has just started to spend from their portfolio, it creates a subsequent hurdle that cannot be overcome even if the market offers higher returns later in retirement.
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