By Peter Chiappinelli & Ram Thirukkonda
Summary
Defined Contribution (DC) plan participants are haunted by an invisible risk called sequence risk (sometimes called sequence-of-returns or path dependency risk), that is, getting the “right” returns but in the “wrong” order. Sequence risk in the retirement phase has been studied extensively. Sadly, not as much attention has been paid to sequence risk during the accumulation phase, but it is equally important. Sequence risk rears its head in this way: Even if an individual employee does everything “right” – participates in the plan, defers income religiously, takes full advantage of the company match, and even gets his exact expected return from his investments – he can still fall victim to disappointing final wealth outcomes if the order of those returns works against him. Current models of asset allocation – the most popular being static, or predetermined, target date glidepaths – “know” that sequence risk exists, but behave as if there is nothing that can be done to mitigate it. Valuation-based dynamic allocation, on the other hand, can help soften the bite.