# Under the Hood: What You Need to Know About Sequence of Returns in Retirement

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There is always a great deal of conversation among advisors surrounding portfolio returns. Although the emphasis has been on the level of returns, there is another issue which has not garnered as much attention but is highly significant: the sequence of returns. Assuming a portfolio averages a specific annual return over some period of time, the order in which the returns occur can play a significant role in the portfolio’s ending value. This is especially true for clients who are making deposits and/or withdrawals. In short, when cash flows are present, the order of the returns is a major factor in the portfolio’s terminal value. To begin, let’s look at the assumptions I used in the analysis.

Assumptions

The analysis includes three different scenarios with three portfolios in each. Scenario One assumes there are no cash flows. Scenario Two assumes annual withdrawals of \$50,000. Scenario Three assumes annual deposits of \$20,000. We’ll also assume the portfolio averages 9.8% per year (geometric return), has a beginning value of \$1 million and covers a 10-year period. Taxes, commissions and fees have been ignored.

In Portfolio A of each scenario, the returns will begin at 35% and decrease by 5% each year with a final return of negative 15%. Portfolio B in each scenario will reverse the order of the returns, beginning with negative 15% and increasing by 5% each year, ending with 35%. Portfolio C in each scenario will assume a 9.8% annual return which is the geometric return of portfolios A and B. This return will not vary. The zero percent return was omitted in the first two portfolios. The order of returns in each portfolio are displayed in the following table.

Scenario One: No Cash Flows

When cash flows are absent, the order of the returns is irrelevant. In this case, all portfolios reach the same terminal value of \$2,541,167, although each takes a different route (see Graph A).

Scenario Two: Annual Withdrawals of \$50,000

When withdrawals are present, the order of returns is important. In Scenario Two, Portfolio A begins with higher returns and ends with lower returns, making it the winner by a wide margin (see Graph B).

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Portfolio A’s ending value of \$2,021,257 is \$734,927 greater than the ending value of \$1,286,330 in Portfolio B. Portfolio C’s ending value is \$1,752,844 which falls between the other portfolios.

Portfolio A is superior because the higher returns experienced in the beginning help support the annual withdrawals. Conversely, Portfolio B lags because the lower returns occurred in the beginning.

This supports the idea that the worst possible scenario for a retiree making withdrawals is the simultaneous occurrence of negative returns and withdrawals in the early stages of retirement. This unwelcomed convergence was precisely what happened to many who retired in February 2000 or September 2007, just prior to stock market peaks.

Scenario Three: Annual Deposits of \$20,000

In Scenario Three we find the result of a \$20,000 annual deposit with all three portfolios. In this scenario, Portfolio B came out on top (see Graph C). This is because the portfolio experienced its best returns when it contained the greatest amount of money. The difference between the best (Portfolio B) and the worst (Portfolio A) was \$293,971. Once again, Portfolio C finished in between the other portfolios.

The order of returns is important, but only when cash flows are present. When withdrawals are considered, it’s best to have higher returns in the beginning. When contributions are made, the portfolio will benefit more if the higher returns occur at the end of the period, when the portfolio contains the most money. In all cases, the order of returns makes no difference when cash flows are absent.

Individuals who are planning to retire and begin withdrawing from their portfolio should consider a worst-case scenario before making the leap. Because once the bottom falls out, especially if the retiree is dependent on the withdrawals, the longevity of the portfolio could be at risk.

To view or print the full report, click here.