The perspective that sequence risk is cataclysmic for retirees is only half of the equation, and the right sequencing of returns can create unexpected wealth in a portfolio, according to John Rekenthaler, director of research at Morningstar.
In an analysis published this week, Rekenthaler looked at what happens to portfolios when sequence risk is applied during the accumulation phase of investors’ lives.
He found they can benefit from the sequence of returns in the opposite way retirees are hurt. In other words, investors who suffer poor returns early in their accumulation phase and great returns at the very end do much better than when the boom time comes early.
Retirees, conversely, do not want to experience poor returns early in their retirement—instead, great returns up front can magnify wealth in a way that simply saving cannot.
Rekenthaler illustrated what he calls “sequence opportunity” with a 35-year-old investor who starts putting $10,000 a year, inflation-adjusted at 3% per year, into her company’s 401(k) plan. If her portfolio grows at 15% annually during the first decade, followed by a decade of slower growth with 8% returns and a final 10 years of growth at 1%, her account balance would be $1,076,401.
While that looks OK on paper, Rekenthaler said, it’s a pretty dismal result considering the investor put in $300,000 over 30 years. After adjusting for inflation, the total drops to $443,463.
However, with the sequence of returns flipped, the portfolio endures the worst returns first, then bumps along at 8% for 10 years and hits 15% for the last decade. If that happens, Rekenthaler calculated, the investor’s account balance at the end of accumulation is $2,535,347. Adjusted for inflation, the total would be $1,044,529, on the same $300,000 invested.
“The order in which investment returns arrive is typically regarded as a risk faced by retirees. While correct, in that inopportune losses can sink retirement portfolios, that tale is incomplete,” Rekenthaler concluded. “For one, return sequences can help performance as well as hinder it. For another, the sequence of returns also affects employees who are continually adding to their portfolios. Their retirement fortunes are therefore determined not only by how much they save and how well their investments perform but also by when the tides flow.”