There’s no feeling like when you are close to retirement and you know you have a really huge, juicy nest egg waiting for you. But what if I told you there was one tiny thing you may have never heard about that can ruin it?
I don’t mean ruin a small part of your retirement plan, but all of it!
Before you get too scared, hold on a minute…
The flip side is that this tiny thing could make you even wealthier than you thought! If you’re confused and curious enough already, then it’s time to learn about the best kept secret in retirement planning: sequence of return risk.
What Is Sequence Of Return Risk
In simple terms, sequence of returns means how and when you get interest on your investment. Another way to look at it is the order of returns.
For example, let’s say the predicted average return on your investment over the next twenty years of your life would be 8%.
However, we all know that averages are spread out unevenly. So, if you get 1% return for the first ten years, then 15% over the following decade, the average still comes to 8%.
Or you can get 15% for the first decade, followed by 1% in the next decade, you’d of course still get 8% average.
The problem, therefore, is what order the high returns come vs the low returns. Because if you get great returns in your first 10 years, that will really boost your retirement success odds. And if you get negative returns the first 10 years, it won’t ruin your retirement, but you will have to watch it closely and make changes as you go along.
Now before we get into that, let’s discuss…
Why Does The Sequence Of Returns Risk Matter To Retirees?
Understanding sequence of return risk will help you plan your withdrawals better.
Have you ever wondered why you are advised to only spend 4% of your retirement funds per year? Why not 5% or 6%?
As with all things mathematical in nature, nothing is arbitrary and there is a logical explanation. If everything was based on a straight line return, based on historical performance of a 60% stock and 40% bond allocation, you should be able to spend 6% each year, with inflation adjustments, and your money would last much longer than thirty years.
Notice, however, I said that that was all based on a straight-line return. As we all know, investment returns are not a straight line.
And that’s why there is so much support given to the 4% rule, which we’ve talked about before. Because the 4% rule gives you more wiggle room when it comes to getting bad returns in your first decade of retirement, which is what the sequence of return risk describes.
Financial Planning expert Michael Kitces summarizes it well when he says: “Simply put… the sustainability of portfolio withdrawals is driven far more by the sequence of returns that occur, than the actual long-term return itself.”
And that’s why sequence of returns risk matters so much. If you want to make sure your retirement assets lasts 30 years or longer, you have to be aware of the returns that you get in the first 10 years of your retirement.
What Are The Downsides?
Going back to the scenario in the previous section. Let’s say your retirement starts off with an unfortunate turn of events, something like an economic meltdown, and you experience zero or negative growth the first couple of years.
If you decided to take 6% out of that figure, it means you are eating into your principal already. So, by the time the market corrects itself, you could be down a significant portion, and your investments may never recover fully.
For example, if we start out at $1M, and get a negative 9% return. So your $1M goes to 910K, and you also take out $60K on top of it. So you are now at $850K.
The next year you get a -12% return, so your $850K becomes $750K. And then you take out another $60K, so your portfolio is now $690K.
In the third year of your retirement, your $690K gets a -22% return, and your ending balance is now $540K. Take out your $60K, your overall portfolio is $480K.
Wow, so that’s been a pretty terrible three year period, right? You might be thinking, “yeah Scott, these numbers are bad, but this is pretty unrealistic.”
Well, what I just described to you is the years 2000-2002 for the S and P 500.
To prevent this unfortunate outcome, you need to watch your investments to see how they perform initially and make adjustments if things do take a turn for the worse in the first few years.
You also need to make sure you are properly diversified so that not all of your investments are down the same amount at the same time. Yes, I think the S and P 500 is a great fund to have as part of your portfolio, but only owning that is not a fully diversified portfolio.
In my mind, the sequence of returns is the single most important factor as to how long your portfolio will last.
That might come as a shock because a lot of the emphasis has been placed on how much money you have saved up (which is also important), but the keyword is sustainability. If you want to sustain your portfolio, you need to watch your returns and withdrawals, especially in the early years of your retirement.
That being said, sequence of return risk isn’t all bad news. As with all risks, there is a positive side.
What Are The Upsides?
Just as the market can be cruel, it can also be very loving.
Going back to our example, let’s say you start with $1M. Then you get a 31% return, so your portfolio is now $1.3M. You take out 6%, so $60K of your initial balance, and your new total is $1,240,000.
The next year, you get an 18.4% return, so your new balance is $1,468,000. And you again take out your $60K, so your account is down $1,408,000.
And the next year, let’s say you get an even 20% return, so your new balance is $1,689,000. Again, you take out your $60K, and your ending balance is $1,629,600.
Again, some of you may thinking, well Scott, this is nice, but isn’t this too rosy of a projection? Well, I just described to you what would have happened if you retired in 2019, and got the returns from the S and P 500 during 2019, 2020, and 2021.
So, if you retired in 2019 with returns this fantastic, distributing 6% over the first three years shouldn’t put a dent in your long-term distributions.
What returns you get in those first few years play such an important role in the longevity of your retirement and also in the level of stress and worry that you’re going to have in retirement.
If you get some great returns, your portfolio could increase quite a bit, even with withdrawals, in those first few years. As we just saw, it’s possible for your portfolio to grow 50%, while still taking distributions, in just 3 years.
But it’s also possible for your portfolio to be cut down in half in just 3 years, leaving you in a really tenuous position.
The question then is……
How To Plan Around Sequence Of Return Risk
Planning around the downsides of sequence of return risk is kind of like negative preparation for retirement. It may not feel good, but it can protect you from really nasty shocks and set you up for unending comfort.
When you have accepted that the order of returns is an important factor, you can work on a few solutions with your financial advisor.
First, make sure you have adequate cash reserves, in case the market goes down for an extended period of time.
Second, make sure that you have more than just stocks in your portfolio. Yes, bond rates are low, and you will likely never make as much with bonds as you will with stocks. However, when the stock market is down by 30%, it isn’t likely that bonds will be down by that much.
When Coronavirus started, and the market was down by 30-35%, my clients who had stocks and bonds saw their stock portfolios down a lot, but their bond portfolios were flat! Which means we were able to take distributions from there instead of selling stocks when they were low.
Third, probably the best way to protect yourself from sequence of return risk is by using a dynamic spending strategy. Unlike a static spending strategy like the 4% rule, where you take out the same amount every year, a dynamic spending strategy allows you adjust your spending each year in response to market conditions.
There are different dynamic spending strategies, but they each operate as a safeguard against sequence of return risk. What that strategy means is that when your portfolio performs really well in a given year, you’re allowed to spend a little bit more money. However, if the market is having a rough time, you have to cut back too.
To prevent you from under or overreacting, dynamic spending strategy has a floor of how little you are allowed to withdraw each year (for example, 2.5% of your portfolio), and a ceiling (such as 6.5%).
This strategy will help you protect against the two extremes of sequence of return risk: you won’t run out of money or be left with too much money.
For this to work as it should, you would need to speak with your financial advisor to determine what your floor and ceiling will be, and which dynamic spending strategy in particular is best for you.
Conclusion
Planning for retirement comes with a lot of surprises. While some are pleasant, others not so much. As scary as the sequence of return risk might be, there are ways to beat it. If you would like to know more about sequence of return risk and how to safeguard your retirement nest egg, go to StartMyRetirement.US and book a call for us to create your one page retirement plan.