One of the greatest risks to a successful retirement is out-living your assets. This could be caused by unaccounted-for inflation, uninsured medical expenses, or just living a lifestyle your assets cannot support for the long term. But sometimes you can save tenaciously, plan fervently, live frugally, adhere to all commonly accepted investing principles and still have your retirement nest egg dwindle. One possible cause of this scenario could be the risk from your sequence of returns.
Sequence of returns risk can be summarized as the risk from the order in which investment returns occur and the impact it has on the longevity of withdrawals available during retirement. Table 1 shows a very basic example:
Retiree A and Retiree B both retired with $1,000,000 and are withdrawing $4,000 per month. Furthermore, they both experienced the exact same returns which averaged 7% per year, yet Retiree A’s account balance had $41,000 more than Retiree B’s after three years of retirement. How did that happen? The answer is sequence of returns. Retiree B, whose down year in the market happened early in retirement will end up with less than Retiree A, whose down year happened later in retirement. In Table 1, you can see the impact over just three years; the impact can be exponentially larger over an entire 30-year retirement.
One thing to note is that the sequence of returns will not have any impact on a buy-and-hold portfolio. If you do not add or withdraw money during the time period, then two portfolios with the same average return will end with an identical account balance, regardless of the order of investment returns during the period. Sequence of returns risk only appears when you are actively drawing down a portfolio.
You may have heard the reasoning that only withdrawing 4% to 5% of your starting retirement value should guarantee success since the stock market has historically gone up by 8% to10%, and that as long as the market averages over 4.5%, you’ll be set. Well, let’s look at what would have happened to a typical retiree over the last 100+ years. Beginning in 1871, the S&P 500 has had a compound annual growth rate of 8.92%. According to research compiled by The Retirement Café, when we look at rolling 30-year returns of the S&P 500 to represent the average retirement, beginning in 1871, there are 108 such periods. However, depending on when you actually retired and the sequence of investment returns you experienced (especially early in your retirement), you could have surprisingly different results.
In this chart you see the 108 different 30-year average rates of return vs. the ending portfolio value of a retirement that started with $1,000,000 and withdrew $45,000 (4.5%) per year. Obviously, the goal is to keep your retirement dollars above the $0 line. In this example, the retiree would have gone broke nine out of the 108 times. Even though about 80% of your ending portfolio value is explained by your average return there is still significant variation. For example, look at the red rectangle. Here are three portfolios that experienced approximately the same rate of return, but the ending value for each varied from roughly $0 to almost $5,000,000. Circled in red are two more extreme examples. To the left are three portfolios that only averaged about 3% throughout their 30-year retirement, yet never went below $0. To the right is a portfolio that did go broke, even though it had an average rate of return of 6.8%. So what explains this additional variation? Sequence of returns.
How does a retiree combat sequence of returns risk? One way would be to ensure the stock market only goes up for the first 4 or 5 years of your retirement. However, if you are not confident you can accomplish that, here are a couple more realistic ideas. One way is to take a fixed percentage from your account rather than a fixed dollar amount. If you draw 4.5% from your account every year regardless of what the underlying value is, you will eliminate all sequence of returns risk. However, your monthly income from your investments will fluctuate from month to month while, for most retirees, your monthly bills do not fluctuate significantly.
Another way is to reduce the standard deviation of the returns of your portfolio. If two portfolios both average 7%, but one of them varies between 4% – 10%, while the other oscillates from -15% to 22%, the second, more volatile portfolio will have higher sequence of returns risk. You can reduce the standard deviation and minimize the volatility by adding cash, bonds, and other low-correlation assets to your retirement account.
While we can’t promise to make the market only go up for the next five years, we can help you build a portfolio and develop a retirement distribution strategy to avoid exhausting your assets too quickly. If you would like to discuss your specific financial situation, give us a call at 800-234-9584 and ask to speak with one of our Certified Financial PlannerTM professionals today. Your choice is your future!
PCI’s archived blog entries are dated, the rules and statutes referenced may have changed. The analysis or guidance within these blog entries may have become stale, dated, or no longer accurate. PCI will not update or change these entries to reflect the latest analysis or development.
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