Measuring Sequence of Returns Risk

Abstract

The authors discuss the nature and importance of the concept of sequence risk, the risk that a bad return occurs at a particularly unfortunate time, such as around the point of maximum accumulation or the start of decumulation. This concept is especially relevant in the context of retirement savings, where the implications for withdrawal rates of a bad return can be particularly severe. They show how the popular “glidepath” or target-date savings products are very exposed to such risk. Three different measures of sequence risk are proposed, each of which is intended to inform investors of the probability that a chosen investment strategy may not deliver desired withdrawal rates, and hence these measures are intended to aid investment choices; conventional performance measures such as Sharpe or Sortino ratios are only indirectly related to this ability to achieve a given withdrawal experience. Finally, the authors note that, using US data, very simple portfolios comprising equities and bonds can achieve very low probabilities of failure to achieve popular desired withdrawal rates, such as 5% a year, as long as the equity component is “smoothed” by switching in and out of cash using a simple trend-following rule.

TOPICS: Volatility measures, downside-only measures, performance measurement

Key Findings

• • Sequence of returns risk is particularly important for retirement savings and glidepath or target-date savings are very exposed to it.

• • Three new measures of sequence risk are proposed to help identify the probability of failing to achieve desired pension savings withdrawal rates.

• • Simple retirement portfolios where the equity component is smoothed using trend following can reduce sequence risk significantly.