A Different Perspective on Sequence-of-Returns Risk

Financial markets experienced significant volatility in 2020, both on the upside and the downside, related to the coronavirus and its economic impacts. Stocks passed through a swift and short bear market, followed by a speedy rebound and then a rally late in the year related to vaccine optimism.

Importantly, T. Rowe Price recordkeeping data indicate that during this period the vast majority of U.S. target date investors stayed the course with their investments and thus were likely to end the year with higher account balances than when they began. Indeed, our data show that U.S. target date investors were eight times more likely to keep their investment allocations intact than U.S. non-target date investors, confirming that target date investors are using these investments appropriately for the long haul. 

Still, the dramatic market swings of 2020 may have led some investors to question whether such volatility could adversely affect their retirement outcomes. In this paper, we revisit our analysis on sequence-of-returns risk and the potential impact on account balances when there is a significant market drawdown near the time of retirement. 

Investors saving for retirement must consider a range of factors, including the objectives they wish to achieve and the risks they must take to achieve their goals. One factor that often receives significant attention is the concern that portfolio losses around retirement may impact the ability to support postretirement income needs. This risk is often known as sequence‑of‑returns (SoR) risk.

We recognize that investors may have different retirement objectives, and differing objectives will result in different prioritization of investment risks.¹ While some investors, given their individual circumstances, may prefer a strategy that limits the variability of account balances around retirement, the majority of retirement investors focus on achieving a durable, sustainable income stream to support their retirement needs. 

Poor returns experienced close to retirement can impact the likelihood of premature exhaustion of portfolio assets. As a result, many investors understandably pay close attention to movements—particularly downward movements—in their account balances as they approach retirement. Some investors intuitively may gravitate toward strategies that prioritize stable portfolio balances around retirement.

However, a singular focus on the impact of market movements around retirement does not capture the complete picture when it comes to factors that potentially could lead to premature exhaustion of portfolio assets. One needs to consider the full range of risks and their impact on retirement outcomes over the entire investment life cycle. 

Focusing solely on the potential for short‑term losses near retirement does not take into account an investor’s complete financial situation. Investors face other significant risks―including the risk that an overly conservative portfolio will not achieve the growth required to sustain a desired level of postretirement income. In our view, investors are more likely to achieve their goals by balancing these different risks, both before and after retirement.

Defining Sequence‑of‑Returns Risk

SoR risk goes beyond simple volatility risk because it is a function of both the timing of market returns and the timing of portfolio contributions and withdrawals. When cash flows occur over an investment horizon, the sequence of returns―whether monthly, quarterly, or annually—may have a considerable impact on outcomes. While contributions before retirement and withdrawals after retirement both can produce SoR effects, withdrawals after retirement are typically of greater concern because they may “lock in” losses after a period of poor returns, ultimately leading to premature exhaustion of portfolio assets. 

As a result, conventional wisdom assumes that in the event of a large drawdown near retirement, investors with relatively conservative asset allocations will be better off because a conservative portfolio will mitigate the impact of a negative portfolio shock. However, this discounts the possibility that following a more growth‑oriented strategy during the accumulation phase could provide a larger portfolio balance going into retirement (i.e., the distribution phase).

In other words, the benefit of having a larger accumulated balance going into retirement may outweigh the negative impact of even a large market decline close to or soon after retirement. While a more growth‑oriented portfolio might experience a relatively larger percentage loss in a market downturn, it likely still will be worth more in dollar terms, even after that decline.

To put it another way, consider two newly retired investors: One suffers a 5% decline on a USD 900,000 portfolio, while the other experiences a 10% loss on a USD 1 million portfolio. A 5% decline would reduce the first investor’s portfolio to USD 855,000, while a 10% loss would leave the second investor with USD 900,000—or USD 45,000 more than his or her more conservative counterpart. The second scenario still results in a larger portfolio balance, even though the percentage loss is twice as large. This is why we believe retirement investment strategies should focus not only on the potential for loss in percentage terms, but on potential outcomes in dollar terms.

SoR Risk in Target Date Investing

A key facet of target date design is the construction of asset allocation glide paths that evolve over time and are focused on achieving specific outcomes. It is critical to align those glide paths with the investment objectives that investors aim to achieve.

In general, glide paths with greater emphasis on supporting long‑term income needs will have greater exposure to equities and other growth assets. Glide paths with greater emphasis on reducing balance variability around retirement will feature larger exposures to less volatile assets, such as fixed income and cash. The principal value of target date funds is not guaranteed at any time, including at or after the target date, which is the approximate year an investor plans to retire.

Target date glide paths typically begin with higher allocations to equities and then gradually rebalance into fixed income assets so that the portfolio becomes more conservative over time. Because target date strategies are designed to span an investor’s entire life cycle, there typically is not a sharp transition from preretirement to postretirement positioning. A glide path that is more conservative at retirement typically will have been relatively conservative in the years leading up to retirement. 

While concerns over SoR risk usually center on the risk of a large loss near retirement, investors cannot ignore the possibility that an overly conservative glide path is likely to deliver low returns during the accumulation phase. This means that a conservative glide path ultimately could increase an investor’s risk at retirement by providing a long‑term series of portfolio returns that are not adequate to support postretirement income needs. 

Conversely, for investors focused on long‑term income, the potential benefits of a growth‑oriented glide path could outweigh the impact of even a large market decline close to retirement by allowing them to accumulate larger portfolio balances during the accumulation phase.

Historically, reductions in portfolio volatility typically have come at the expense of reductions in expected portfolio returns. Over shorter periods, equity returns have been more volatile relative to fixed income assets. However, the higher short‑term volatility of equities also has been associated with higher long‑term returns compared with fixed income assets. This equity risk premium has proven durable over long periods, facilitating wealth accumulation by retirement investors.

Managing SoR Risk Requires Glide Path Trade‑Offs

The implication of these long‑term historical relationships is that any attempt to mitigate SoR risk by reducing equity exposure also will require target date investors to lower their postretirement income expectations. In fact, a more conservative glide path actually might increase the risk of premature portfolio exhaustion during the withdrawal phase if an investor is forced to take larger withdrawals from a smaller asset base to meet his or her income needs.

In this sense, asset allocation is a two‑edged sword: While reducing portfolio volatility could mitigate SoR risk, the potential for lower expected returns introduces another risk to retirement income. What ultimately matters is the net effect of these two opposing forces as they are reflected in the glide path.

To illustrate this point, consider two identical investors, H and L, who make exactly the same contributions to their retirement accounts over time; the difference being that H follows a higher‑equity glide path, while L follows a lower‑equity glide path.

Should a severe equity bear market be encountered just before retirement, L is likely to experience a lower level of losses. Historically, however, investors with lower‑equity glide paths have been more likely to have lower portfolio balances heading into a bear market. The relevant question, then, is which risk is more important: Would a smaller percentage decline leave L better off, or would having a larger portfolio value going into the bear market leave H better off despite suffering a larger percentage loss?