The biggest fear for most retirees is running out of money before running out of years. The risk of running out of money can be minimized in several ways. Most potential retirees try to build the largest nest egg possible. Many carefully manage what they spend every year. Others carefully manage their asset allocation and asset location. However, retirees have no control over the biggest financial risk to their retirement……sequence of returns risk.
Experiencing market declines in the early years of your retirement may have bigger consequences than you might think. Several years of negative returns early in retirement can prove to be catastrophic to your retirement plans. The reason for this is the fact that you are withdrawing money from your portfolio for your annual expenses. This, in turn, makes it more difficult for your portfolio to recover down the road.
The average annual return for a 60%/40% portfolio (between 1926 and 2019) was 8.8%. As you would expect, if the retiree was to get an 8.8% annual return each year while withdrawing approximately 4% annually, the portfolio would actually grow over time without fear of ever running out of money. However, the range of annual returns for a 60/40 portfolio during this period of time ranged from -26.6% to 36.7%. If the retiree experiences a number of negative annual returns early in retirement while simultaneously withdrawing money for annual expenses, a severe decline in portfolio value is likely. This risk is referred to as “sequence of returns risk.”
Let’s take a look at how the sequence of returns can have a dramatic effect on your portfolio value and financial security. Let’s imagine two retirees both with $1,000,000 of assets at the time of retirement. They both decide to withdraw $50,000 from their respective portfolios every year. Retiree A will experience the following sequence of returns for the first six years of his retirement: -10%, -5%, +5%, +10%, and +20%. Retiree B will experience the same annual returns but in the opposite order. Both retirees will experience the same average annual rate of return. We will ignore inflation for this example.
Retiree A:
| Year | Withdrawal | Rate of Return | Balance |
| 1 | $50,000 | -10% | $855,000 |
| 2 | $50,000 | -5% | $764,750 |
| 3 | $50,000 | 5% | $750,487 |
| 4 | $50,000 | 10% | $770,536 |
| 5 | $50,000 | 20% | $864,643 |
Retiree B:
| Year | Withdrawal | Rate of Return | Balance |
| 1 | $50,000 | 20% | $1,140,000 |
| 2 | $50,000 | 10% | $1,199,000 |
| 3 | $50,000 | 5% | $1,206,450 |
| 4 | $50,000 | -5% | $1,098,627 |
| 5 | $50,000 | -10% | $943,764 |
Retiree B had almost $80,000 more than retiree A after just five years even though the only difference between the retirees is the order in which they experienced the annual rate of returns. Their average annual rate of return is identical.
When inflation is coupled with a poor sequence of returns, the consequences can be devastating. Let’s take a look at two identical retirees with $1,000,000 portfolios. Both have 70%/30% stock to bond allocations and both decide to initially withdraw $50,000. This time we will include inflation and have each retiree adjust their annual withdrawals by the previous year’s inflation rate. Retiree A retires in January of 1973 while retiree retires just two years later in January of 1975.
| Retiree A | Retiree B | |||
| Withdrawal | Balance | Withdrawal | Balance | |
| Year 1 | $50,000 | $851,102 | $50,000 | $1,222,968 |
| Year 2 | $54,695 | $688,455 | $53,359 | $1,298,572 |
| Year 3 | $61,150 | $807,552 | $56,142 | $1,172,605 |
| Year 4 | $65,258 | $824,140 | $59,921 | $1,238,786 |
| Year 5 | $68,662 | $713,020 | $65,547 | $1,306,162 |
| Year 6 | $73,357 | $712,196 | $74,664 | $1,453,939 |
| Year 7 | $80,164 | $703,637 | $83,493 | $1,312,867 |
| Year 8 | $91,315 | $722,653 | $90,499 | $1,607,057 |
| Year 9 | $102,113 | $594,706 | $93,858 | $1,743,978 |
| Year 10 | $110,681 | $636,351 | $97,792 | $1,796,752 |
| Year 11 | $114,789 | $601,044 | $101,248 | $2,125,181 |
| Year 12 | $119,601 | $525,535 | $105,182 | $2,595,003 |
| Year 13 | $123,826 | $503,511 | $106,718 | $2,431,477 |
| Year 14 | $128,639 | $481,582 | $111,036 | $2,647,061 |
| Year 15 | $130,516 | $343,051 | $116,219 | $3,040,886 |
| Year 16 | $135,798 | $236,425 | $122,265 | $2,976,975 |
| Year 17 | $142,136 | $113,291 | $129,175 | $3,604,808 |
| Year 18 | $113,291 | $0 | $132,534 | $3,758,560 |
| Year 19 | $0 | $0 | $136,852 | $4,049,180 |
| Year 20 | $0 | $0 | $140,307 | $3,854,473 |
| Year 21 | $0 | $0 | $144,241 | $4,866,855 |
| Year 22 | $0 | $0 | $148,177 | $5,602,088 |
| Year 23 | $0 | $0 | $152,687 | $6,730,860 |
| Year 24 | $0 | $0 | $155,086 | $8,239,510 |
| Year 25 | $0 | $0 | $157,678 | $8,760,150 |
Retiree A ran out of money in just 18 years while retiree B had over $8.7 million to leave to his heirs at the end of a 25-year retirement. The only difference between these retirees is the year they retired…..1973 vs 1975. Retiree A experienced of combination of market downturns (losing 45% of its value in just two years) along with high inflation (8% and 9%) very early in his retirement. Both of these factors had devastating effects on his portfolio and its longevity. On the other hand, retiree B enjoyed a bull market in the first two years (37.2% and 23.8%) of his retirement. In addition, inflation had fallen to a more moderate 4% during this period of time. These factors initially increased the size of his nest egg and allowed it to grow rapidly thereafter.
As you can see, the timing of retirement can have dramatic effects on your financial security. Unfortunately, these market changes can only be identified retrospectively and the timing is essentially a matter of luck.
There are some factors that can help mitigate sequence of returns risk. The first is choosing a reasonable initial withdrawal rate. As you saw in the example above, both retirees chose an aggressive initial withdrawal rate of 5% (25% higher than the generally recommended 4%). In fact, had retiree A chosen a 4% withdrawal rate (instead of 5%), his portfolio would have lasted him 33 years. Secondly, appropriate asset allocation can help mitigate the risk associated with the sequence of returns. Since stock and bonds are usually negatively correlated in their returns (usually moving in opposite directions), having some bonds in your portfolio can allow you to withdraw funds from your bond position allowing your stock holdings to recover after a dip. A cash reserve can be helpful for the same reason. Finally, the ability to tighten your belt in bear markets is vitally important to minimize sequence of returns risk. Decreasing the amount that you need to withdraw from your already diminished portfolio allows more of the portfolio to recover in the future. One way to decrease your withdrawal amount is to forego inflation adjustments during market downturns.
