When you are saving for retirement during your working years, your primary concern likely revolves around accumulation. You want to ensure that you have a sufficiently large nest egg to fund your retirement according to your preferred lifestyle. The conventional wisdom is that you would be safe with a 4% withdrawal rate in a 60-40 (60% equities & 40% bonds) portfolio. So, if you intended to have $40,000 in retirement income from your retirement portfolio, you would need to save $1,000,000. With so many other demands on your attention, that's probably a good start. However, there are several risks you should also consider. This is the risk that several down years before or after retirement can substantially lower your ability to meet your preferred funding goals during retirement. This post will focus on how the sequence of returns risk can affect your retirement goals.
The sequence of returns risk is one of several risks that can endanger the most diligent of savers. Other risks include:
The sequence of returns risk falls under Investment Risks.
The market returns during the ten years encompassing the five years just before retirement and the five years just after retirement have a substantial effect on a retiree's success. Success is defined as the ability of the retiree to meet their preferred retirement spending goals.
In the five years leading up to retirement, your portfolio has the most power to increase due to the compounding returns on the relatively large size. You also can save more after 50. In 2021, you can save $7.000 (as opposed to $6,000) per year in your Roth or Traditional IRAs. And, you can save an additional $6,500 as a catch-up after 50 in your 401(k) on top of the usual $19,000.
But, in the five years before and just after retirement, several negative return years in a row can have a particularly harmful effect on your portfolio.
A similar string of negative returns outside of this sensitive 10-year zone has a more negligible effect on your retirement success. This is because you have time to recover.
You can take several steps to reduce the risk of the sequence of returns on your retirement portfolio.
First, you can limit your exposure to equities during this decade, encompassing the five years before and after retirement. Alternatively, you could monitor your equity investments' Price/Earnings ratio ("P/E ratio"). When the P/E ratio is high, you should reduce your exposure to equities. When the P/E ratio is low, you should increase your exposure to equities according to your typical plan.
For instance, the P/E ratio for the S&P500 in 2020 (the latest measure) is 38.31. The median P/E ratio has been 15.85, and the average has been 16.84. That would suggest that the S&P500 is expensive. If you were in the decade five years before and after retirement, you might consider reducing your exposure to equities.
If you want to retain some exposure to equities, nonetheless, you could diversify your retirement portfolio internationally - or to alternative investments. Diversification will protect you to some extent, provided that these assets are not correlated with equities.
Purchasing an annuity (deferred or immediate - depending on if you are retired or still working) can also help you reduce your exposure to the sequence of returns risk. By increasing your income floor (the guaranteed income you receive during retirement), you protect yourself from the market's volatility. When others are panicking, you can focus on your family and hobbies, knowing that you'll be ok.
Instead of purchasing an annuity, deferring Social Security to age 70 provides you with a higher income floor. Because of the annual Cost of Living Adjustments ("COLA"), it is also inflation-protected to some degree.
You could also work longer. Research has shown that delaying retirement by up to six months can have a similar impact on saving one percent more for 30 years.
I have created a model to show my clients how the sequence of returns risk could affect their retirement portfolios after retirement. You can access it by signing up for the free report: The Readiness is All: An Essential Retirement Savings Report. I will email the sequence of returns excel spreadsheet to you as part of the welcome package.
It shows how an individual with the same retirement wealth, withdrawal rate, and portfolio allocation would fare if they began their 30-year retirement in any year between 1928 and 1990.
To focus the point, the model starts with the baseline assumption that the individual would retire with $1,000,000. They would take an initial 4% withdrawal, so, $40,000. That $40,000 withdrawal is then inflation-adjusted according to the inflation rate of the prior year. So, for example, if they retired in 1941, their 1942 withdrawal would be $40,000 inflation-adjusted to $42,048 in 1942 because the annual inflation rate in 1941 was 5.12%.
I set the initial portfolio allocation to 60% exposure to the S&P 500, 35% to 10-year Treasury Bonds, and 5% to 3 year Treasury Bills.
For simplicity, I set the portfolio allocation in stone for the entire 30 years. And, to show the impact of the sequence of returns risk, the model goes negative. Obviously, in the real world, you would adjust your withdrawals down and reallocate your portfolio in the face of several negative years.
When you sign up for the free report: The Readiness is All: An Essential Retirement Savings Report, you will receive the excel spreadsheet I created. You will have the ability to change the starting wealth and the initial withdrawal amount. You will also be able to change the portfolio allocation.
The fun part is that you can change the first year of retirement and see the chart change dynamically. You will also see the terminal wealth after 30 years. And, I have a box that also shows you the mean return over the 30 years period, as well as the standard deviation. Finally, I included the minimum return and maximum return over the 30 year period. This will give you a sense of the volatility of even a 60-40 portfolio.
Let's look at a few examples:
If you retired in 1929 with $1,000,000, took an initial withdrawal of $40,000 (which is subsequently inflation-adjusted), you would have a final wealth after 30 years of ~$210,347.
The S&P500 had returns of -8.30% in 1929, -25.12% in 1930, -43.84% in 1931, -8.64% in 1932, and 49.74% in 1933.
In this screenshot from the spreadsheet (that I will send to you when you sign up for the free report: The Readiness is All: An Essential Retirement Savings Report,) you can see that the minimum return of the portfolio (60/30/5) was -27.08%, and the maximum return was 32.73%. So, diversification may have saved you from running out of money completely.
You can change the portfolio allocation on the spreadsheet to see how doing so would have saved your retirement if you run out of money after 30 years. Alternatively, you can see how a change in the portfolio allocation would have ruined an otherwise successful retirement.
Now, what if you had retired in 1939?
Well, you would have run out of money during your retirement (for purposes of this model - with the caveats mentioned above). In 1939, the S&P500 had returns of -1.10%, -10.67% in 1940, -12.77% in 1941, 19.17% in 1942, and 25.06% in 1943.
This simple model doesn't tell us the impact of the sequence of returns on the failure or success of the retirement. And, I'm not suggesting that sequence of returns risk is the only factor contributing to retirement ruin for this retiree: a few wars, inflation, and political uncertainty were other likely factors.
In any case, this retiree ends their retirement with a $1.1m deficit.
As emphasized above, this is just a model. In the real world, they would have reallocated their portfolio and/or reduced their withdrawals dynamically as it shrunk.
Finally, if you had retired in 1949, you would have ended your retirement with $1.4m to give to your children, grandchildren, or to charity.
I encourage you to sign up for the free report: The Readiness is All: An Essential Retirement Savings Report to receive your copy of this sequence of returns spreadsheet.
I should note that the free report, offers some useful information that you can put into action right away to improve the chances of a secure retirement.
As an estate planning attorney in Austin, Tx I have the opportunity to help clients with ensuring that their estate plans work together with their wealth and retirement planning goals.
As you can see from this brief examination of the effect of the sequence of returns risk on retirement portfolios, without a comprehensive plan, you leave yourself at the mercy of luck. The differences between a retiree starting their retirement in 1929, 1939, and 1949 is stark.
With proper planning, you can ensure that you have a successful retirement. As such, you will be able to meet your retirement spending needs, as well as your wealth and legacy goals.
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