The Funny Thing About Sequence of Returns Risk…

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If someone decides to retire and live off of their investment portfolio, an important detail called the sequence of returns risk can be one of the most critical components to comprehend.

You might have an understanding or at least a notion of the 4% rule that helps give you some direction in retirement planning. The idea is that you likely can take out 4% from a given portfolio every year and never run out of money. There are several caveats on that, which I’ll mention later.

But what most folks who aren’t nerds at this stuff might not understand is that what the stock market does right after you retire can determine if your portfolio will stand the test of time. This is the sequence of returns risk and experts tend to agree that the first 5-10 years can really be the make-it-or-break-it period for your portfolio for retirement.

Do you have some flexibility in controlling the sequence of returns risk? Sort of. You can’t control the sequence of returns risk in and of itself… the market will do what it’ll do. However, you can do a few things to help make the impact of a bad market a little less crushing for you.

But here’s the interesting thing about the sequence of returns risk… if you get past those first 5-10 years of retirement with great returns, you might be able to re-adjust your “annual paycheck” to be higher than what you were taking out before. If the stars align, you can get this raise without adding much risk.

Let’s talk more about how the 4% rule and the sequence of returns risk play together and how to get this “pay raise” down the line. This is something that I’m tossing around because we’re about to wrap up year 6 of early retirement. In other words, we’re getting closer to the sweet spot I’d be comfortable with.

DISCLAIMER: You probably already know this, but don’t listen to some stranger on the internet (that’s me!) for your investment advice. Feel free to read this, understand it, and work with a professional to determine if this is right for your situation. I don’t have any cool acronyms after my name like CFP, CPA, or even any other fun acronyms like FOMO. So that’s it – don’t make changes to your retirement plans without talking to a professional first.

Why the 4% rule anyway… or why not?

If you do any digging around in the personal finance community, you’re bound to hear about the 4% rule.

In 1994, William Bengen published “Determining Withdrawal Rates Using Historical Data,” a paper that analyzed the sustainability of various withdrawal rates based on historical stock and bond market performance. He examined different asset allocations and how long a portfolio could last based on different withdrawal rates.

In a nutshell, he determined that a person could withdraw 4% every year from a given portfolio (adjusted for inflation) and not run out of money. This was even if you hit a worst-case scenario like a market crash right after you retired. That said, he even thought that 5% might be more realistic.

That’s where the 4% rule was born. Unfortunately, too many folks run with it without understanding all the details of this study. For instance:

• This was based on a 30-year time horizon of withdrawals. If you’re in early retirement, your timespan could be a lot longer than 30 years. If you’re a late retiree, you might not need 30 years.
• The portfolio that worked for this was based on an allocation of 50-75% in stocks.
• This was all based on historical data from 1926 to 1992. Ever heard the saying “past performance is not indicative of future results”? Yup, things can and will be different eventually. Just because it would have worked in the past doesn’t guarantee it’ll work now.
• This is based on consistent spending. If you don’t need to pull as much from your portfolio every year or you pull more than you planned, it throws this study out the door.
• The study aims to fulfill the desire to not end up with $0 at the end of the time frame. So you could end up with $1 left when you die and that’s considered a success (with nothing to pass on to any heirs, if desired). Or you could end up with a portfolio that’s vastly greater than what you started with. Maybe that’s what you want so you can pass money down, but maybe you’d rather be able to spend more now while you can. This study doesn’t consider these scenarios.

The list of caveats could go on and on. Overall though, Bengen’s research helped us to understand what’s now known as the 4% rule, which laid the groundwork to at least have a starting point for retirement planning.

You’re going to hear folks tell you that he’s too conservative and you can take more out of your portfolio every year. The renowned “financial expert” Dave Ramsey last year said that you can spend 8% out of your portfolio without going broke. I’m in the camp of thinking he doesn’t understand how this works at all. If the market takes a dive for years right after you retire, 8% is going to crush your portfolio. But hey, if you’re an old guy famous for being grumpy on the air, I guess you can say whatever you want for ratings.

That said, Bengen himself now says it makes more sense nowadays to look at a 4.5-4.7% safe withdrawal rate.

On the other side of the spectrum, you have a lot of folks who say that 4% is not conservative enough. I met Dr. Karsten Jeske (aka Big ERN) from the Early Retirement Now blog at a FinCon conference years ago. Great guy and smarter than most folks could only imagine. He’s written a series of posts called The Safe Withdrawal Rate Series. There are currently over 60(!!!) extensive (and I mean EXTENSIVE) posts about safe withdrawal and he generally recommends a safe withdrawal rate of somewhere more in the 3.25-3.5% range.

So, with all these things said, you can see that the 4% rule isn’t necessarily the answer for everyone. It’s important to understand these nuances or work with a financial planner before just throwing caution to the wind.

And just to get this off my chest, if you hear any advisor telling you to plan your retirement based on 80% of your current income (or any number), just walk away. That’s been a pet peeve of mine for way too long. How much you need for retirement has absolutely no correlation to how much you earn at your job.

With that logic, someone bringing in $100k/year who only spends $50/year and saves the other $50k would need to anticipate spending $80k in retirement… why? Why would their expenses go up $30k/year in retirement? It might, but it’s not your income dictating this.

The money you need in retirement has everything to do with your expected expenses – not what you’re making. Track your expenses, folks – that’s the key to getting a baseline for your spending. Then you can adjust those projections for where you think you’ll spend more/less in certain categories in retirement.

I use Quicken Simplifi to track our expenses. I’ve tried other personal finance software over the years and Simplifi is the one I’m happy to be using now. It lets you connect all your financial institutions to eliminate manual entry, gives nice reports (particularly on your spending!), and works well from any browser or your cell phone. You can read my post, Breaking Up With PocketGuard: Why Quicken Simplifi Won Me Over for more info.

As a side note, Quicken is currently running a 40% off sale on Simplifi. I’m not sure how long this sale will run, but at $3.59/month (paid as $43.08/year), this is a great time to try it out!

As for us, when we retired at the end of 2018, our net worth was worth a little over $1.1 million. We had already sold our home so that wasn’t included but we still had a rental property (a duplex) with a small amount of equity in there.

Nonetheless, according to the 4% rule, we could withdraw up to about $44,000 from a $1.1 million portfolio. Combine that with the rental income we had coming in and we were easily able to cover our $45-50k of annual spending.

What the heck is the sequence of returns risk?

Ok, so why do we even need to have such low safe withdrawal rates? If the stock market returns an average of about 10% per year (or around 7-8% after taking into account inflation), shouldn’t we be able to take out 7 or 8% every year and be just fine?

Hey, you could get a lucky run and make it work… but that’s not a bet I’d feel comfortable taking.

Here’s the problem – a little factor called the sequence of returns risk can be the most critical factor in whether or not you run out of money during retirement.

So what exactly is the sequence of returns risk?

Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor.

Investopedia – Sequence Risk: Meaning, Retirement, and Protection

Um, ok – so what the heck does that mean?

Essentially, you’re going to have some good gains and growth in your portfolio, but you’ll also have some bad years. The order of your investment returns can have a big impact on how well your portfolio does overall.

The risk part is that if you’re unlucky enough that the stock market goes down the toilet during your first several years of retirement, that can be big trouble. If you’re forced to sell your investments with negative returns early in retirement, you could be eating away too much from your principal. That leaves less in the pot to grow and trying to recover from that pitfall to cover your retirement will be difficult or sometimes impossible.

Let’s look at an example…

You have a portfolio of $1 million. You decide that you’re going to withdraw $50,000 for your first year of retirement (5% of your portfolio). That brings you to $950,000. Life is good.

Then the stock market crashes – what the @#$%??? That lingers on for a couple of years. When you go to take your second withdrawal in year 2, your portfolio is down 30% and worth $665,000. You sell off and take out $51,000 ($50k + 2% after adjusting for inflation that year). Your portfolio is now worth $614,000.

At the beginning of year 3, you got “lucky” and the stock market only dropped another 10%. Your portfolio is now worth $552,600. You sell $52,020 worth of stock (you had 2% inflation again on top of last year’s money). You’re now left with $500,580… ouch.

You’ve only been retired for just over two years and your portfolio is now half of what you started with. That’s bad. And it could drag on for further years or maybe then move into slow gains. And that’s only with a moderate recession. In a deep recession, things could be a whole lot worse.

That’s the crux of the problem. If you get smacked by a bad market during your first several years of retirement, you could be in big trouble. Even if you have good gains several years later, it’s much more difficult to make up for those years of pulling so much principle out of your nest egg.

Overall, you’ll have a lot of good years of returns from the market (69% of the years have been positive returns) and you’ll have some bad years with negative returns. That’s the way it goes. But the order that those happen after your retirement makes the biggest difference and THAT’S what the sequence of returns risk is all about. The risk of that order is that you’ll get the bad returns first, which can crush your portfolio and make for an extremely difficult time getting back on track.

That’s exactly why the renowned expert on retirement income, Dr. Wade Pfau said:

Pfau (2011b) estimated that the cumulative portfolio returns and inflation in the first 10 years of retirement explain about 80 percent of final retirement outcomes.

— Journal of Financial Planning (June 2013) – The 4 Percent Rule Is Not Safe in a Low-Yield World

There are some ways to help mitigate this by setting a more conservative safe withdrawal rate (maybe 3.5%), structuring your portfolio to utilize a bucket strategy, working part-time if/as needed, and being flexible on your spending to make big cuts if needed. None of these are guarantees but they can all help.

The point is that the sequence of returns risk is a massive part of retirement planning and shouldn’t be overlooked. It’s easy to say, “Yeah, we’ll figure it out if things get rough.” However, it’s much harder to do this later than it is before you retire.

For instance, if you just think you’ll get a job if you get those unlucky years of bad returns, who’s to say that you’ll be able to? Chances are that if times are really bad, unemployment will be high because businesses are struggling and laying off people to try to save money where they can.

So if you’re planning on retiring soon, understand the severity that the sequence of returns risk can play on your retirement and be careful.

And if you need a good way to manage your investments, I highly recommend the Empower Dashboard. It’s what I use – it’s free, it’s powerful, and it works great. Not only that, but their built-in retirement planner can help you easily run simulations to help you prepare for all these possibilities we’re talking about. Check it out here.

Tell me more about this pay raise, kind sir!

On the other side of the spectrum, sometimes the sequence of returns plays out in your favor. That’s the boat I’ve been fortunate enough to be in for almost the past 6 years now. Things have gone very well and I count my blessings for that.

It may also present an opportunity that I’ve been contemplating recently. Can I utilize this fortunate solid sequence of returns to garner a pay raise AND make our withdrawal rate safe(r)? Maybe.

Folks like Karsten Jeske, who are much smarter than I am, think we’ll probably see some sort of recession sooner rather than later based on the inverted yield curve and other factors. Maybe that’ll happen soon or maybe it’ll be years from now. Regardless, I am smart enough to know not to wear rose-colored glasses thinking the stock market’s going to continue on this awesome climb forever.

But… here’s something pretty cool. If our portfolio does continue growing over the short term, we can do one of two things:

• Leave everything alone and continue as is
• Re-evaluate our safe withdrawal rate

If we simply continue doing what we’re doing, every year will minimize our sequence of returns risk even more. And the longer that goes on, the more likely it is that not only will our portfolio last us for the long haul, but there’ll be a good chance we’ll be able to leave our daughter, Faith, one helluva windfall when we’re gone.

However, there’s another option that I’ve been considering… we could re-evaluate our safe withdrawal rate (SWR). Here’s an oversimplified example with a sample portfolio and some simple numbers to explain. Here’s how a 4% withdrawal rate might play out (we’ll pretend inflation is at 2% each year)…

I used some actual percentages of growth here. Know that this could have gone very much the other way as well, but for retirees of the past decade, it’s been a good run thus far!

Here’s the point, the sequence of returns risk is heavily weighted toward your first 5-10 years of retirement. Have a good run during those years, keep doing what you’re doing, and you’ll be likely to make it just fine in the long run. Have a terrible first 5-10 years right after you retire and it could make life a little more difficult in the future (unless your withdrawal rate is super conservative to begin with).

But considering it’s been a good trek of growth, let’s look at the option of redefining and recalculating our safe withdrawal rate.

Although this would restart our sequence of risk returns timeline, we could do two cool things:

• Go with a more conservative rate to ensure a higher rate of success than the general 4% rule provides (if you’re unconvinced that 4% is not going to be successful)
• Take out a larger amount than we’ve already been taking out… a pay raise!

In our case, our net worth has grown from $1.1 million since we retired at the end of 2018 to over $1.8 million as I write this. Almost all of that is in our investment portfolio so we’ll use those numbers for this.

Let’s say that over the next year or so, the market continues growing bringing us to something like $2 million (I like easy, round numbers!). So what if we decide to recalculate our safe withdrawal rate (SWR) at that time and go with something a lot more conservative?

If we would decide to do a SWR of 3.25%, that would give us an initial withdrawal of $65,000. That’s a pretty hefty pay raise from the ~$50k withdrawals we’re currently taking! Or at 3.5%, we’d be looking at an initial withdrawal of $70,000… living the baller life, friends!

Setting our SWR at 3.25% would be an extremely conservative number to use, too. That would keep us out of the weeds in almost every market situation.

But that’s a scary thought nonetheless. Again, this starts over the biggest weight of our sequence of returns risk. With a 3.25% SWR, we should be just fine, but it would still make me a little uncomfortable if the market went south right after we decided to do this.

At the same time, we’re doing ok on our $50k withdrawals now so it doesn’t mean we’d have to stick with the pay raise. We could always withdraw less or just not spend that increase if times were bad and I didn’t feel comfortable with the numbers for whatever reason.

Bear in mind that we’ve also been bringing in a little income each year as well. The Route to Retire blog will probably give us about $5k this year – not a whole lot, but still nice to have for our vacations.

Now, this is all just a thought right now. I’m not in a hurry to make a change but if our luck continues and we happen to get to that fancy random $2 million net worth, maybe we’ll make an adjustment. On the other hand, if the inevitable bear market hits sooner than later and lingers on, then I’ll shelve this pay raise idea.

Pretty cool either way though, right?

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Plan well, take action, and live your best life!

Thanks for reading!!

–Jim