Sequence Risk – Understanding the Luck Factor

Sequence Risk – Understanding the Luck Factor

Academy of Financial Services

September 2009 

Executive Summary

While a distribution portfolio’s exposure to sequence risk changes over time, sequence risk never really goes away unless the withdrawal rate is constrained considerably.

A practical method for advisers to meas­ure this exposure to sequence risk is through evaluation of the current proba­bility of failure rate.

The fundamental withdrawal rate for­mula is portfolio value ($X) times a withdrawal rate (WR%) to equal the annual distribution amount ($Y). There­fore WR% = $Y / $X Because sequence risk relates to the order of returns, espe­cially negative returns, when the portfolio value ($X) decreases, the inverse rela­tionship increases the withdrawal rate

(WR%), which results in an increased probability of failure.

The distribution period should be meas­ured primarily from a fixed target end date rather than from the date of retirement (that is, based on life expectancy). This establishes a continuously reducing period of remaining years that reflects the distribution period likely to be expe­rienced by retirees.

This paper will discuss three methods advisers may use to evaluate the expo­sure of a portfolio to sequence risk

  • Adjust WR% as market return trends suggest
  • Adjust portfolio allocation to mitigate exposure to negative market returns as market trends suggest
  • Start with a reduced WR% to reduce exposure to the impact of declining markets on the probability of failure

Reliance on a single simulation to be accurate for a lengthy distribution period is not prudent. Rather, the current likelihood of failure should be reviewed regularly to ensure the with­drawal is still prudent.


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