What Makes Sequence of Returns Risk So Dangerous
From: thinkadvisor.com
Ron Surz uses a thought experiment to clarify sequence of returns risk and its perilous implications for target-date investors
We recently advised readers of an obvious but overlooked retirement risk — what retirement planner Dirk Cotton calls sequence of consumption risk.
Now Ron Surz, target-date fund expert and alert ThinkAdvisor reader (and contributor), warns of another obvious but overlooked risk related to sequence of returns — in fact, the very thing he says that gives the risk its potency: namely, high account balances.
“The thing that impacts the effect of the sequence of returns is the size of the account at the time of return,” Surz tells ThinkAdvisor in a phone interview.
The principal of San Clemente, California-based Target Date Solutions demonstrates his point through the prism of the 2008 financial crisis.
Noting the difference between accumulation accounts and retirement accounts is that balances are highest for the former at the ending point and for the latter at their starting point, Surz suggests a “Benjamin Button” type experiment that reverses the sequence of returns on these portfolios.
So a saver who contributes $2,000 a year in a balanced 60-40 portfolio from age 25 to 64 between the years 1970 and 2008 accumulates $800,000. Despite ending up in the horrible market year of 2008, our saver still winds up with impressive results, as the standard theory holds, because he had a generally positive sequence of returns.
But now hit the Benjamin Button and watch the savings accumulate in reverse, from 2008 to 1970. The same saver now winds up with $1.2 million — a whopping 50% more — even though he started his savings with the disastrous market year of 2008, which shrunk his initial contribution.
But Surz’ explanation for this makes intuitive sense; it’s the account balance. Losing a chunk of that $2,000 is less damaging than losing the same percentage of an over $1 million account.
“The returns that occur when account balances are high are much more critical than when account balances are low,” says Surz.
So later matters much more than earlier during the accumulation phase and conversely earlier matters more than later in the better known sequence of returns risk in retirement portfolios.
