Whenever people first start learning about retirement planning and formulating their strategy, one of the biggest misconceptions they have is this:
If stocks make an average of 10 percent (or so) per year, then I should be able to simply subtract 3 percent for inflation and safely withdraw my earnings of 7 percent every year, right?
If only it was that simple …
Unfortunately, even though this seems like a pretty logical conclusion (on paper), history has shown us that it’s a recipe for financial disaster, and you’ll be certain to reduce your retirement nest egg down to nothing.
Why is this? It’s all because of a little-known phenomenon called “sequence of returns risk”.
Never heard of this before? Let me show you how it works.
What is Sequence of Returns Risk?
The sequence of returns risk has to do with understanding how fluctuations in both market return as well as inflation can significantly impact how long your savings lasts. In fact, it was entirely the premise behind the famous “4-Percent Rule”.
To better help you understand how the sequence of returns risk works, let’s illustrate the concept like this:
- 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 30-year actual values of each nest egg are as follows:
- Vince: $529,240
- Larry: $10,356,508
- Mary: $5,277,407
So what happened? Why did each person conclude their 30 years with a different amount?
Because there was one small detail I failed to mention
… when each person retired …
- Vince: 1931
- Larry: 1952
- Mary: 1965
What does the year someone retires have to do with it?
As you can see by the graph, it can impact your portfolio by quite a lot!
Vince’s Poor Returns
Unfortunately, since poor Vince retired in 1931, if we look at the stock market data compiled by NYU, we’ll see that the first year had an almost negative 44%return for the year!
That first year has a huge impact on our portfolio. It basically chops it in half. As a result of our portfolio shares being so low now, any money we withdraw from the portfolio will have virtually twice the decreasing effect that it would normally have.
As luck would have it, the remainder of the decade continues to be pretty dismal. In fact, in 1937, he takes another devastating hit negative 35% which drops the balance down even lower!
Despite his “average” 10% annualized returns over time, his portfolio never seems to bounce back.
Larry’s Extraordinary Returns
Larry, by contrast, is the winner of the group. By chance, he retires during a stellar decade for market returns: 53% in 1954, 44% in 1958, and so on. As time goes on, his portfolio value quickly doubles in value which lessens the effects of any withdraws. The result despite his annualized rate only equaling out to 10% per year, his portfolio continues to grow onward and upward.
Mary’s Modest Returns
Mary retires in 1965 with what we can call a mediocre sequence of returns. Again, even though the returns average out to 10% per year, the order and magnitude of those returns isn’t exactly enough to sway her portfolio one way or the other significantly. The end result is that her portfolio grows upward beyond Vince’s but slower than Larry’s.
Just because each person experienced approximately 10 percent year over year average growth, their portfolios all turned out to be quite a bit different from one another.
Ultimately, in our simple example, we saw that what happens in the first 10-15 years of your retirement will inevitably shape the fate of your nest egg. This not only means “how much money the markets return”, but it can also mean:
- How much inflation there is (remember: inflation is like a negative market return)
- How much you personally withdraw from your nest egg
This is no coincidence. Using a much more analytic approach, financial researcher Michael Kitces concluded the same thing about that first decade being the “sweet spot” for how the sequence of return risk would affect us later on.
To put it bluntly: What happens with your money in the first 10 years of your retirement is VERY important!
What Can We Do?
Okay. So the first decade could make or break how successful our retirement is. How then can we plan for this in the future if we don’t know ahead of time what’s going to happen?
Not to worry! As I mentioned earlier, this is entirely the principle that the “4 Percent Rule” was built upon and sought to overcome.
Up until the 1990’s, the false assumption I gave in the introduction was exactly the thinking that many financial planners would use to make recommendations to their clients. To make matters even worse, the media had famous investors like Peter Lynch were advocating that strategies such as this were perfectly okay.
A financial planner from California knew better. His name was Bill Bengen, and he had an idea for how we could combat sequence of returns risk: Back-test different withdrawal rates for every year going back to 1926 and see how long your money would have lasted.
In other words, start with a withdrawal rate of 3.0 percent and pretend you retired in 1926. How many years did your money last? Do the same thing for 1927, 1928, and so on. Once that was done, he did the same thing with 4.0 percent, 5.0, and so on.
As you might guess, the data suggested that a safe withdrawal rate of 4.0 percent was the optimal value to use. 4.0 percent worked 100% of the time for a minimum 33 years. Most of the time, it worked for 50 years or more. It wasn’t overly safe, but it wasn’t too risky either.
A few years later, another group of financial researchers published a different article called the Trinity Study that more or less a similar conclusion.
But it didn’t stop there. Both Bengen, the Trinity Study, and a number of other financial researchers have all found many other useful conclusions as they go back and analyze the hypothetical retirement portfolios over the past 100 years.
I’ve done quite a bit of research on safe withdrawal rates and packed it all into my latest book “Early Retirement Solutions: How Much Money Do I Really Need to Retire and Achieve Financial Freedom?” (available on Amazon both in ebook and print format). In it, you’ll not only find a bunch of useful retirement planning strategies, but you’ll also learn how to use them to positively help your goal for ultimate financial independence. The net result will be whatever you desire: Reaching retirement sooner, becoming richer, or having more safety and security that you’ll never run out of cash!
Readers – What do you think of the sequence of returns risk? How do you feel it could impact your financial goal, and what do you plan to do to manage it?
About the author: DJ is the financial guy behind My Money Design; a blog that is all about achieving financial independence and making your life better. In addition to writing on his blog, he also is assembling a collection of easy-to-follow, early retirement strategy books. Please check them out on Amazon.