Sequence Of Returns Risk And How It Affects Your Retirement


Wow! Even Tom Brady is going back to work after experiencing sequence of returns risk after retiring. Playing for 23 years in the NFL is a lot. At age 44, I hope he doesn’t injure himself. I’m on a retirement kick, so let’s keep the subject going.

Sequence of returns risk refers to the risk of receiving lower or negative returns early in a period when withdrawals are made from an investment portfolio. Withdrawals are made from an investment portfolio usually during times of financial duress or more traditionally, during retirement.

If you happen to retire before a bear market hits, you face sequence of returns risk. Therefore, it’s generally better to retire near the bottom of a bear market rather than near the top of a bull market.

If you retire near the bottom of a bear market, your finances have already been battle-tested. Chances are higher good times will return while you’re still unemployed.

What Is Sequence of Returns Risk?

If you are planning on eventually retiring, you must be aware of sequence of returns risk.

Also called sequence risk, this is the risk that comes from the order in which your investment returns occur. Sequence of returns risk is the risk that the market declines in the early years of retirement, paired with ongoing withdrawals.

If your retirement portfolio declines by 10-20% and you withdraw at a 4% or higher rate, this combination could significantly reduce the longevity of your portfolio. Due to sequence of returns risk, it is important to have a more conservative portfolio as you get closer to retirement. Once you do retire, capital preservation becomes even more important.

The people who had most of their net worth in stocks in 2007 and 2008 got a rude awakening. Many likely had to delay their retirement for years. Or, they simply couldn’t spend and do as much in retirement.

Here is my recommended proper asset allocation of stocks and bonds by age. You’ll notice how the stock allocation declines with age and the bond allocation increases with age. Bonds are defensive investments that tend to outperform stocks when stocks decline.

If you also invest in real estate and alternative investments, please take a look at my recommended net worth allocation by age. This article will provide a more complete picture to help counteract sequence of returns risk.

How To Mitigate Sequence Of Returns Risk

The easiest way to mitigate sequence of returns risk is to lower your safe withdrawal rate during down years. In fact, for the first two or three years of retirement, try living off the FS safe withdrawal rate, even if times are good. This will help train you to live on less when the next downturn inevitably arrives.

The concept is similar to paying yourself first by automatically contributing the maximum you can to your 401(k) or IRA with each paycheck. You will learn to live on less.

Lowering your withdrawal rate in retirement is something you can control. You can also alter your asset allocation to be more conservative before a down market arrives. However, once a bear market hits, changing your asset allocation may already be too late.

An alternative solution to combatting sequence of returns risk is to generate supplemental retirement income. For example, you could start working a minimum wage job, consulting, giving piano lessons, or making money online. Or, you can do what one Financial Samurai reader did and ask for his old job back, but in a part-time capacity.

In other words, even if your investment returns start declining after you retire, you have the ability to offset the negative effects of losing money. Any supplemental retirement income you generate will help reduce your withdrawal rate. Further, it may also help you buy more investments on the cheap.

Eventually, the good times will return again. Your goal is to last as a retiree until the good times return. In the meantime, do whatever you can to survive.

Sequence of Returns Risk Examples

Here are two examples of sequence of returns risk.

In both scenarios, the S&P 500 returns are identical, except they are in reverse order. As a result, the Compound Annual Growth Rate (CAGR) of each scenario is the same.

Scenario A is what most retirees prefer. Good returns for three years followed by two years of bad years. By lowering your safe withdrawal rate for the first three years, you’ll be able to better withstand negative returns in years 4 and 5. Further, as you grow older and wealthier, your asset allocation should become more conservative.

Scenario B is the nightmare scenario for new retirees. As soon as you hang up your boots, your retirement portfolios start getting pounded. It’s already stressful enough to retire from a job after so many years. But to then experience a bear market may really freak you out. You’re less likely to go more aggressive in your investment portfolios in year three and beyond to make up for your losses.

The key to surviving the Painful Scenario is to lower your withdrawal rate and generate supplemental income so you aren’t forced to sell your investments after a big decline. Ideally, you’ll be able to generate enough passive income to invest more during the downturn.

The 4% Rule Is Too Aggressive Due To Sequence of Returns Risk

The 4% Rule was devised in 1994 by Bill Bengen. He found that an initial withdrawal rate of 4% of a portfolio, with distributions adjusted for inflation each year thereafter, provided at least 30 years of income. The 4% rule worked even for individuals who retired just before significant bear markets.

However, we no longer live in the 1990s when the 10-year bond yield was between 5% – 7%. Interest rates are much lower, which means dividends, rental income, and other income streams are also lower. Further, investment returns expectations over the next 10 years have all declined. As a result, we will need to accumulate more capital to generate a similar amount of income.

I recommend not withdrawing at a 4% rate when the 10-year bond yield is at 2% and we’ve gone through a prolonged bull market since 2009. Further, elevated inflation is also hurting the purchasing power of retirees.

Even Bill Bengen mentioned in a comment on this site that he is steadily earning supplemental retirement income through consulting. Generating extra income once you no longer have a day job is key to surviving sequence of returns risk.

In my case, I’m generating supplemental retirement income online through advertising revenue on this website. I love to write and talk about personal finance on my podcast.

As a result, I’ve found my ideal combination of doing what I love and getting paid for it in retirement. I just have to be careful not to spend more than 20 hours a week online. Otherwise, it’ll start feeling like work.

Sequence of Returns Risk And Stagflation (2022+)

The worst-case scenario for retirees is experiencing negative retirement portfolio returns and high inflation. Stagflation refers to slower economic input and high inflation. The combination of high inflation hurting a retiree’s purchasing power and negative portfolio returns is one of the worst scenarios for retirees.

2022 is shaping up to be a year of potential stagflation. If stagflation doesn’t come in 2022, it may come in 2023. As a result, it is vital for retirees today to be more cautious about their withdrawal rates. Capital preservation is key. The last thing you want to do is lose a bunch of money and have to go back to work.

Other risky times from the past include the years 1929, 1933, and 1966. Study history so you can minimize experiencing a similar bad fate.

Sequence Of Returns Risk Could Crush Your Retirement Dreams

Since I fake retired in 2012, some readers have commented I’m too conservative with my investments and my investment outlook. I beg to differ as the majority of my net worth has been invested in risk assets since I left.

However, as someone who was in Asia during the 1997 Asian financial crisis, went through the 2000 Dotcom bubble, and had significant assets during the 2008-2009 global financial crisis, I have some experience. And the good thing about having gone through a lot of pain is that subsequent painful events tend to hurt less.

Once you’ve made enough money to never have to work again, you need to protect your capital. You’ve already won the game, so stop running so hard. You might sprain your ankle or worse!

Final Sequence Of Returns Risk Example

To help bring you back down to earth, here is a final example of sequence of returns risk from the website Retire One. It shows how a retiree at the beginning of a down market ends up with 65% less after 15 years. The down market returns of between negative 5% and negative 15% aren’t even that bad!

The problem, obviously, is the consistently high withdrawal rate of 5.55% starting in year one all the way up to a 14% withdrawal rate in year 15. Hopefully, none of us are so robotic as to keep on withdrawing at a higher and higher rate while the markets decline.

The other problem is five consecutive down years in the market right after you retire. That is straight up misery right there. Thankfully, this is unlikely to occur based on historical returns. Three consecutive down years is the worst we should really expect.

More Sequence Of Returns Risk Examples

The upshot is that after 15 years in retirement, the retiree still has 35% of their original retirement portfolio left. You don’t want to die with too much money. Otherwise, you will have wasted all that time working to accumulate that money.

But if you had retired early, let’s say at age 50, you’re still only 65 years old. Therefore, it’s up to you to figure out the proper way to best decumulate your assets, invest, and spend your money. I’ve actually got a post on decumulation coming up.

The best way to counteract sequence of returns risk is to start with a low withdrawal rate and slowly work your way up. The goal is to bank any investment overages to help you weather downturns. Of course, if you retire right before a big bear market, you can always try to get your old day job back until the good times return.

Reader Questions

Readers, how are you prepared for sequence of returns risk? Is stagflation the worst-case scenario for new retirees? Are you worried about sequence risk at all given bear markets seem to last shorter than the average two years nowadays?

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