Sequence of Returns: A Substantial Risk to Retirees

There are certain constants in life that we all assume as part of our day to day lives.  Among them are death and taxes.  We also presume that it will always be the case that 7 – 6 = 1.  While this is true in math class, it is not always the case in financial planning.   How can this be you might wonder?

The reason this is the case in financial planning is that investment returns are no lineal.   Investors too commonly make the mistake of assuming that if they have an average return of 7% annually, that they can simply spend 6% of their assets, and they will continue to grow their principal by a factor of 1% per year.  This may or may not be true depending on the timing of their investment returns.    An average return is a set of randomized results that arrive at a longer-term average.   If you arrive at an average return of 6%, it is often the case that you may not have had a single year in which you actually earned precisely 6% on your investments.   As part of this long-term average, you will have negative and positive years mixed together.  While markets are remarkably consistent over the longer term, they are highly unpredictable in the short term.

What happens if you happen to realize a significant number of those negative years early on as opposed to several years from now?  While this is irrelevant if you are savings money for retirement for the next 25 years, it is extremely impactful if you are among the large number of retirees who use their investment portfolio as a source of income.   Why does this matter?  If you have an average return while saving money for 25 years, the result is identical regardless of when the returns occur.   However, the moment you introduce withdrawals into the equation, the math changes dramatically. 

Below is an example from a white paper done by Fidelity Investments several years ago.   In this case:

Investor A and Investor B both begin with $100,000.

Investor A and Investor B both average a 6% annual return for 25 years.

Investor A and Investor B both withdraw $5,000 a year from their portfolio.

What you can see from the end result is that by year 20, investor A is completely out of money, while investor B has more than doubled their asset value by year 25.   The difference is the sequence of returns.  In this example, the annualized returns are simply reversed.   Year 1 for investor A became year 25 for investor B, and vice versa.   Simply reversing the order in which the returns took place produced a dramatically different result. 

    Portfolio A   Portfolio B 
         Year       Return      Balance      Return       Balance
            0         $100,000         $100,000
            1           -15%        $80,750            22%        $115,900
            2             -4%        $72,720              8%        $119,772
            3           -10%        $60,948            30%        $149,204
            4              8%        $60,424              7%        $154,298
            5            12%        $62,075            18%        $176,171
            6            10%        $62,782              9%        $186,577
            7             -7%        $53,737            28%        $232,418
            8              4%        $50,687            14%        $259,257
            9           -12%        $40,204             -9%        $231,374
           10            13%        $39,781            16%        $262,594
           11              7%        $37,216             -6%        $242,138
           12           -10%        $28,994            17%        $277,452
           13             19%        $28,553            19%        $324,217
           14             17%        $27,557           -10%        $287,296
           15              -6%        $21,204               7%        $302,056
           16             16%        $18,796             13%        $335,674
           17              -9%        $12,555            -12%        $290,993
           18             14%        $8,612               4%        $297,433
           19             28%        $4,624              -7%        $271,962
           20               9%        $0             10%        $293,658
           21             18%        $0             12%        $323,297
           22               7%        $0               8%        $343,761
           23             30%        $0            -10%        $304,885
           24               8%        $0              -4%        $287,890
           25             22%        $0            -15%        $240,456
Average Return              6%             6% 

Withdrawal Rates

The next question is how do you defend against such a risk?  The answer is rooted on two key variables, which are withdrawal rate, and asset allocation.   It is not possible to time markets with any degree of consistency.  As a result, neither you or your financial advisor have any real ability to control when such returns occur.  The stock market is positive approximately 75% of the time, while the bond market is positive approximately 94% of the time.   This data is remarkably consistent over the longer term as referenced earlier.  However, because the short term is so unpredictable, no matter how well you design a portfolio, the sequence in which your average returns occur is little more than luck. 

Numerous financial planning studies on withdrawal rates have demonstrated that if you plan to spend down assets from your investment portfolio as a source of income, then it important to limit that withdrawal rate to 4% annually.   This assumes that you will increase spending over the course of your retirement with inflation, so the annual income is not level.  Using such a 4% withdrawal rate, it is highly probable that you should be able to safely spend down your asset base over the course of 30 years with a 90% confidence rate.   In fact, according to a study reported by Michael Kitces several years ago, 2/3rds of the time, at the end of 30 years you’ll have more money than you started with in year one.   However, 1/3rd of the time you’ll have less positive results, but still not likely run out of money.  In the above example, there is a 5% withdrawal rate ($5,000 per year from an initial balance of $100,000) being attempted.  Yet, even with a 6% average return, the results for Investor A failed within 20 years.  A 5% withdrawal rate is generally considered to be high for someone in the early stages of retirement, and not recommended.

Asset Allocation  

All of the above data on withdrawal rates of 4% is premised on the notion that you maintain a consistent asset allocation that has a risk profile in the vicinity of 50% stock and 50% bonds to 60% stocks and 40% bonds.   This presumes that you do this in a highly diversified way, rather than concentrate in a small group of stocks and bonds.  This also presumes that you do not attempt to time markets, but rather maintain this risk profile through up and down markets.   Introducing too much or too little exposure to the stock market can disrupt your ability to maintain a consistent withdrawal strategy.

As referenced above, a 4% withdrawal rate is generally considered to be a safe rate of withdrawal for a 30-year duration.   If you are retiring at a traditional age 65, this should take you to age 95 years old.  As financial planners, we generally plan to age 95, as it is not uncommon to live into your 90’s anymore.   Average life expectancy is not a prudent measure to use, as this is often misleading due to skewed numbers from those people who die at very young ages due to accidents, drug abuse, suicides, etc.   These tragedies bring down the average life expectancy.  Looking at data from the actuarial society, the information suggests that a couple that reaches age 65 has a better than 75% chance that at least one of them will live into their 90’s. 

In financial planning, all of the data around an individual scenario needs to be considered.  In some cases, a retiree may wish to retiree much sooner than a traditional age, and this would likely require a lower withdrawal rate.   In other cases, a retiree may wish to withdraw a higher percentage of assets in the early years of retirement, and then plan to greatly reduce their spending in latter years.    In such cases, there are strategies that can be implemented to address both scenarios. 

Financial planning is something that must be addressed at the individual level as each individuals circumstance is unique.