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?

Wrong!

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.