The Dynamic Implications of Sequence Risk on a Distribution Portfolio

Journal of Financial Planning: June 2010


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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Retirement Savings and Income Planning