European Street Painting

Understanding Sequence of Returns Risk

To help you understand how sequence of returns risk works, allow me to illustrate the concept using the following example:

  • Three people (Vince, Larry, and Mary) all retire at the same age.
  • They each retire with a nest egg of $1,000,000.
  • They each withdraw the same $50,000 per year for expenses.
  • Their nest eggs contain the same investments: 100% stocks from the S&P 500 earning approximately 10% per year.

Therefore, after 30 years of retirement, if everything above is the same, then they should each have the same amount of money left in their nest eggs, right?


The actual values of each nest egg are as follows:

  1. A) Vince: $529,240
  2. B) Larry: $10,356,508
  3. C) Mary: $5,277,407

So what gives?  Why did each of them end with something different?

The one piece of information I left out was when each person retired …

  1. A) Vince: 1931
  2. B) Larry: 1952
  3. C) Mary: 1965

What does that have to do with it?

As you can see, quite a bit!

We’ll start with poor Vince.  Again, let’s look at the history of stock market returns using data compiled by NYU.  Unfortunately, poor Vince retired in 1931 when stock market returns were almost -44% for the year!

How do you like that?  After just one year, his entire portfolio was virtually cut in half!  Because of this, any withdraws from his portfolio had effectively twice the decreasing effect as they would have had in the beginning.

As time goes on, future returns are never quite large enough to build his portfolio back up to a sustainable level.  As a matter of fact, in 1937, he takes yet another devastating hit -35% which drops his balance down even further!

The end result is that his portfolio never exceeds the original balance.

Larry, by contrast, experiences a nice string of positive year over year returns during the first decade of his retirement: 53% in 1954, 44% in 1958, and so on.

As a result, his portfolio builds up strong and his withdrawals have less of an overall impact.

Mary’s experience starting in 1965 is somewhere in-between Vince and Larry.  She experiences both positive and negative years of returns, but the swings are much more modest.  As a result, her portfolio grows slower than Larry’s but better than Vince’s.

Conclusion: As you can see from this example, average returns don’t necessarily tell the whole story.  As you’re making your necessary withdraws for retirement income, the sequence of those returns is extremely important in determining how much of your assets you’ll use and how long they will last.

Inflation Is Just As Important As the Market Returns

Market returns aren’t the only thing that can negatively impact your portfolio over time.

Inflation, the tendency of everything to rise in price year over year, can also influence your portfolio in just the same way.  You could almost think of it as something like a “negative” market return since the trend is for your money to be losing purchasing power as time goes on.

Similar to how we describe market returns, whenever we talk about inflation, it is often more useful to describe it as an average.  For example, you’ve probably heard that on average inflation increases by 3% year over year.

But again: This can be a little misleading.  The actual rate for each particular year may be higher or lower than this average.  Just like market returns, the exact sequence and magnitude of those inflation values can impact the life of our nest egg.

How to Deal With Sequence of Returns

After reading about sequence of returns risk, you might be asking yourself: How in the world am I supposed to plan for this?  How can I know ahead of time what the sequence of returns will be for the next 30 or years, and then pick a withdrawal rate that will be right for me to use?

The answer: Of course you can’t know ahead of time what the markets will be.  (No one can.)

But you can do this: We can pick a withdrawal rate that is “safe”.

By “safe”, I mean the following.  We’re going to come up with a number to use that will:

  1. Give you the greatest odds of never depleting your nest egg.
  2. But be high enough that it won’t require you to excessively save up more than you need to.

In other words, we need to find the perfect compromise between safety and affordability.

So where do we start?

Enter a Financial Planner from California

As we said, up until the 1990’s, there was a false assumption that you could simply withdraw approximately whatever average returns you were getting from your nest egg.  In fact, there was one prominent figure in the media that stated if you earned 7% per year from stocks on average that you would be okay withdrawing this amount from your nest egg.  (This, of course, was wrong.)

Then, out of nowhere, an unknown financial planner from California wrote an article that would change the way we thought about safe withdrawal rates forever.

The Safe Withdrawal Rate Concept

In the previous chapter, we learned how increasing your rate of investment return would help you create more passive income.

We looked at building a nest egg with assets that gave us a few different rates of return:

  1. A) A bank CD at 2% interest per year
  2. B) Bonds that earn approximately 5% per year
  3. C) Stocks that earn approximately 10% per year

In other words, if you had $1,000,000, these assets could theoretically passively generate the following levels of income for you each year:

  1. A) Bank CD: $1,000,000 x 0.02 = $20,000
  2. B) Bonds: $1,000,000 x 0.05 = $50,000
  3. C) Stocks: $1,000,000 x 0.10 = $100,000

While that might seem pretty obvious, one thing that people often forget is that a higher rate of return could also mean that we might not need as big of a nest egg.

Think back to our Retirement Equation from Chapter 1.  If I wanted to create $50,000 per year of passive income, for example, that I could use to cover my living expenses, then using each of the rates above, all I would need to do is save up the following:

  1. A) Bank CD: $50,000 / 0.02 = $2,500,000
  2. B) Bonds: $50,000 / 0.05 = $1,000,000
  3. C) Stocks: $50,000 / 0.10 = $500,000

Now, let me ask you: Which one would you rather save up?

If you’re like me, I’d much rather go the easy route and only save up $500,000 as opposed to $2.5 million!

As you can see, the withdrawal rate you choose can inversely amplify the size of the nest egg you need to save up.  The larger the rate, the less money you’re going to need to save.

For this simple example, our earnings rate = withdrawal rate.

But is it always?  …

Danger: Average Returns are Not the Same as Guaranteed Returns!

There’s a very good reason I used the example above to make a point and lead you astray …

… nearly everyone makes that mistake when they first get into retirement planning!

(Even yours truly made this rookie mistake.)

What’s more scary is that up until the 1990’s, financial professionals, the people from that $49 billion dollar industry you paid to help you with your retirement planning, believed this to be true and were unknowingly ill-advising their clients.

They would look at:

  • The investments you had.
  • Approximate your average rate of return.
  • Determine how many years you’d need your portfolio to last (basically, estimate how long you were going to live).

… and then use these figures to make your plan.

Think of it like the opposite of a mortgage.  For example, you might have:

  • A nest egg of $1,000,000
  • Be earning an average of 6% per year
  • Expect to be retired for 30 years

In this circumstance, your pre-1990’s advisor would have incorrectly recommended that you could withdraw 6% of your portfolio.  In fact, they might have gone so far as to recommend that you could take out as much as $72,649 per year (a withdrawal rate as high as 7.3%).

But as you’ll soon find out, that would have likely been a HUGE mistake.  And here’s why.

The Difference Between Average Returns and Guaranteed Returns

A “guaranteed return” is exactly what it sounds like: No matter what, you’ll get paid exactly the amount you were quoted for your investment.

The classic example is a bank CD (certificate of deposit).  When you invest in a bank CD, the bank pays you a pre-determined interest rate in exchange for you not using that money.  It’s as simple as that.

(Believe it or not, in the 1980’s and even the 1990’s, it wasn’t that uncommon to find banks offering CD’s with rates as high as 10%.  Could you imagine locking into one of those rates today?)

An “average return”, on the other hand, means that the rate reported was merely an average of the rates that were experienced.  (To get technical, it’s the geometric average.)

Stocks are a very good example where it’s appropriate to report their “average return”.  Each day, stock prices fluctuate up and down.  But at the end of the day (like you hear on the evening news), they often state something to the effect of “stocks were up by 1% today”.  For the common person, it’s not exactly newsworthy to report each and every value that they fluctuated between.

The same is true on an annual basis.  It’s more useful to say that “stocks went up by an average of 10% this year” then to report which values they fluctuated between.

But therein lies the problem:  Those market fluctuations are by no means trivial!  The exact order and magnitude that your investments went up and down can have a dramatic effect on your nest egg as you withdraw money for your retirement nest egg.

This is a very real phenomenon known as “sequence of returns” risk.

Understanding Lead Paint Settlement Cases

Brian Frosh who is a Maryland Attorney General has started an investigation into the practice of many companies which is shady. It is about finding more about those who buy structured settlement from victims who have suffered lead poisoning. They quite often end up buying less than what such settlements provide for.

Filings in the court this week in Baltimore and Montgomery County Circuit has quite a few shocking things to show. The Consumer Protection Division is finding out if companies were involved in such sales have violated the Consumer Protection Act Of The State. It is quite obvious that lead paint victims suffer damages to their cognitive functions. Frosh is concerned about people who are at risk and are vulnerable. It is about finding out whether these people are being short changed and are being acted upon contrary to provisions of state Consumer Protection Act.

The practice is to exchange long-term regular settlement payment for one-time payments which are much lower. Frosh has been able to find out that the onetime payment is just around one-third of what the present value is all about. According to Frosh, it is akin to offering 3 dollars settlement for a ten dollar bill which becomes payable at different dates in the future. The investigation is focusing if the so-called independent advice given by professionals are independent, which is mandated under the law. The legal filings according to Attorney General’s Office are focusing many firms including the likes of Seneca One LLC and Access Funding LLC.

The three attorneys involved are Charles E Smith, Bennett Williams and Anuj Sud. They are vigorously fighting subpoenas which have been served with this investigation. The attorney general’s office is trying to see that the subpoenas are enforced. It would be pertinent to mention that Sud worked as counsel to Access Funding and other such related entities. He was involved in transactions with those who were injured in Maryland in June 2013. Smith is known to have provided independent professional advice to people who entered into such transactions during the same period.

According to Record Access Funding and their related companies were able to garner a total sum of around $15 million from vulnerable and poor Maryland victims from June 2013 to August 2015. The attorney for Smith did not like to comment on the matter, and the attorney for Sud could not be reached.

Further, as per court filings, Sud and Smith state that services provided by lawyers are outside the purview of Consumer Protection Act and the subpoenas are broad and not specific. It also has been found that Wills has offered independent professional advice to Maryland victims who were offered such one-time settlements by Seneca One. Wills’ attorney Tom Donnelly mentions that as per professional rules about confidentially of client information, Wills cannot disclose information which has been subpoenaed.

Donnelly states that his client and he do not have any problem cooperating with the attorney general in this case. However, there are rules laid down under professional responsibility which prohibits them not to divulge the information unless courts order so. It was not possible to reach other officials of Seneca One LLC and Access Funding LLC.

Frosh also states that a few other additional people also have been subpoenaed as a part of the investigation. State lawmakers are also planning to find out ways by which they can strengthen the regulations on companies which are into buying of structured settlements. As many lead paint cases are being settled as personal injuries, the compensation is being distributed as a structured settlement, also referred to as an annuity. As the laws have changed to allow selling an annuity, victims of personal injury cases are cashing in their future payments. It is highly recommended you contact respected companies as there are many which have less than a stellar reputation.

You can read more about annuities here.