Ready For Retirement
Ready For Retirement
3 Ways to Protect Against Sequence of Return Risk in Retirement
James explores the concept of sequence of return risk in retirement planning. Most people are unaware of how risky this is, as it doesn’t become an issue until you begin living off your portfolio.
Responding to a listener’s inquiry about early retirement, James dives into the potential impact of market timing on retirement outcomes.
Learn three actionable strategies:
- Ensure a reasonable initial withdrawal rate.
- Implement a suitable withdrawal strategy.
- Own a diversified mix of assets.
Questions Answered:
How does sequence of return risk impact retirement outcomes?
How can early retirees protect against sequence of return risk?
Timestamps:
0:00 - Ben’s question
3:19 - Sequence of returns matters
6:48 - 3 projections to consider
11:49 - The 4% rule
16:05 - Considerations for early retirees
18:57 - 3 protective takeaways
22:15 - Summary
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One of the unique issues that you're going to face when you retire is something called sequence of return risk. Most people they're unaware of how risky this actually is because it doesn't become an issue until you actually start living off your portfolio, which for most people isn't until you retire. So in today's episode of Ready for Retirement, I'm going to tell you what you need to know about this unique retirement risk and I'm going to give you three things you can do to protect against it. And it's all coming up next, on Ready for Retirement. This is another episode of Ready for Retirement. I'm your host, james Kanol, and I'm here to teach you how to get the most out of life with your money. And now on to the episode.
Speaker 1:Today's episode is based upon a question that comes from a listener named Ben. Ben says this Hi, james, I've been enjoying your YouTube videos and I have particularly been watching the ones where you have a case study from actual clients with names changed. In many of them you show graphs using a static market return assumption to illustrate a projection of the portfolio balance over the retirement horizon. My question, which I hope you can answer in a video sometimes, is how your planning process addresses the concept of sequence of return risk, which is particularly important for those wanting to retire earlier than normal retirees. Thanks for the educational material you publish, ben Ben, thank you very much for that question. I think you're exactly right. And so for those of you who are wondering what's been referring to, check out our YouTube channel on that.
Speaker 1:We do a lot of case studies and in these case studies what we do is we will project out actual client scenarios and we might say this person wants to retire, they are invested in a moderate portfolio. That's just assume there's a growth rate of, say, 6% in that portfolio and they're spending down their portfolio to the tune of maybe 4% per year or so. What doesn't take a rocket scientist to do some basic math that says Okay, if I'm growing at 6% per year and I'm taking out 4% per year, then this software, at least initially, is going to model the portfolio continuing to grow, because you're getting 6, you're only taking 4, there's a net 2%. That's just compounding and continuing to grow the portfolio in this example. So what that makes it look like if you're running financial planning projections is it looks like everything's good. Your portfolio just keeps growing and growing and growing and there's really nothing that you need to worry about. Well, if we could guarantee that you get exactly 6% every single year for the rest of your retirement which of course, nobody can and if we could guarantee that your spending was never going to exceed 4% per year which we also couldn't then that graph would be perfectly accurate. It's just going to show something going up into the right of your portfolio growing even as you're spending down your assets.
Speaker 1:Well, what's been is referring to is the risk of sequence of return, and what that sequence of return risk refers to is the fact that you may have a portfolio and I may have a portfolio and we may retire at the same time. Now let's assume that our living expenses are the exact same and let's assume that your portfolio averages 6% per year over the course of your retirement and my portfolio averages 6% per year over the course of my retirement. If you look at that and I was just to ask you, what do you expect the final outcome to be if we both have the same exact life expectancy or the same exact age starting today? Well, you look at it and you say, okay, you're the same age today, you're going to live for the same amount of time, you're both going to spend the same exact amount out of your portfolio and you're both going to average 6% per year. It seems as if we would have the same exact portfolio value at the end of our retirement horizon or at the end of our planning horizon. That's not the case, though. It does not only matter what my portfolio averages versus what your portfolio averages. What also matters is the sequence in which you achieve those returns.
Speaker 1:So let's say in this case, yes, we both average 6%, but your portfolio did really poorly the first several years. It just went down, down, down, and then it picked up towards the latter end of your retirement, so that the underlying funds averaged 6% per year, whereas my portfolio had the opposite experience. I retired, and I retired into a wonderful bull market, and my portfolio balance grew, grew, grew, grew, and then, maybe in my later seventies, early eighties, things started to flat. Now, or come down a bit, to the extent that we both averaged 6% when you look at the underlying funds within our portfolio, but you and I had significantly different outcomes. The person who retired into a rising market, so let's say that was me. In that case, I probably would have ended up with, in this scenario significantly more assets at the end of the projection or at the end of the day, then you would have and again the reason for this is sequence of return If you are not just dropping in your portfolio value, so your portfolio isn't just going down, but you're retired, so you're also spending down these assets, you have to think of it as you're almost cannibalizing some of your portfolio.
Speaker 1:Here's a perfect real world example of sequence of return risk in action. From 2000 until today, the S and P 500 is averaged about six and a half to 7% per year. So that's well below its longterm average. But from 2000,. If you remember 2000, 2001, 2002, the market at three pretty rough years in a row. Then it recovered, then 2008 happened and things dropped quite a bit. Then it recovered, then 2022 happened and things dropped. And here we are today. The market's averaged about six and a half to 7%.
Speaker 1:Now let's assume that you were tired and put all of your money in the S and P 500 on January 1st of 2000. The S and P cherry picking numbers here. But it's to illustrate a point. You put all your money in the S and P 500 and you say I'm going to take 5% per year out of my portfolio. Well, we just saw what it returned. It's returned six and a half plus percent. You should be fine taking 5% per year out, you would think, until you realize those first three years the S and P 500 lost almost half of its value. Now, not only did it lose half of its value, but you took 5% per year out. So you've really drawn down your portfolio pretty significantly and it's going to struggle to generate enough growth to be able to continue to support those distributions going forward in your retirement. So much so that if we look at the S and P, like I said, since 2000,. As of today, it's up about 6.5% since then, annualized over that time period. However, if you retired and started taking 5% per year out of your portfolio, you ran out of money somewhere around 2018.
Speaker 1:That's the sequence of return risk that I'm referring to. It doesn't matter your average return, it matters the sequence in which you get these returns. Now here's what I want to talk about today. That's just some general background on sequence of return risk. It's also very misunderstood. I think there's this sense or there's this concern that people have. They hear about this, they say, oh, that makes sense. I don't want my portfolio to be dropping and for me to be spending it at the same time. I can see how that's a recipe for disaster. What people wrongly assume is they think that if I retire and the stock market is down, that automatically means I can't spend what I want. That's not the case. I'm going to show you why.
Speaker 1:In a second Sequence of return, risk First was fully fleshed out, I would say back in 1994, through a guy named William Bingen and what he did. He had research. He created this white paper called Determining Withdrawal Rates Using Historical Data. His whole thesis, or his whole point, was wanting to know when I retire, when my clients retire he was a financial advisor what's the most amount of money I can advise them to take without running the risk of them depleting their portfolio balance too early. Now, of course, if you could predict where the market was going to be going forward, this would be insanely easy. You just take less than what the market's going to do, but we don't know what it's going to do. What we can do is we can go back with the past 100 years or so and say what was the highest withdrawal rate could have taken during any different year that people could have retired and still have been assured that their portfolio was going to last for some period of time. Now there's three specific events or three specific time periods that he looked at. Now I shouldn't say there was just three, because he actually looked at every single year since then or over that time period, but there's three really dramatic, negative events that he looked at.
Speaker 1:He called these the little dipper, the big dipper and the big bang Because and this just makes sense look, if you retire, the market is nothing but go up. Of course you can spend money. There's no issue with that. We don't need research to show us that. What we do need research around is if we retire and the market drops, if we retire and inflation skyrockets, what does that mean? For how much we can not just spend, but safely spend for a long period of time, knowing that that money is going to last for us. So when he talks about the little dipper, the big dipper and the big bang, here's the events that he's referring to.
Speaker 1:The little dipper this was the time period in the stock market from 1929 to 1931. This was the early Great Depression years. Now it might seem odd that he's calling that the little dipper. If we're ranking these in order of most impactful to least impactful of these three, the Little Dipper, aka the Great Depression, was actually the third in terms of the severity of that on a retirement portfolio. Here's why yes, the stock market did horribly during that time period. From 1929 to 1931, the US stock market lost about 61% of its value. So you had, say, a million dollars, which would have been a huge amount of money in 1929, a million dollars turned in about $390,000 two years later, three years later, in this example. Now here's the thing that people fail to realize in most cases Inflation was actually negative during that time period. So the real return, yes, the market was down 61%. I should say inflation. There was actually deflation over that three-year time period of negative 15%. So the real return on the US market over those three years was negative 46%. The market lost 61% of its value, but inflation dropped 15%. So there's actually deflation. So the real return was negative 46% over those times.
Speaker 1:The second event that you want to stress test in this white paper he called the Big Dipper. This was towards the latter end of the Great Depression, it was 1937 and 1941, and it occurred during that time where there actually was some inflation. So the US stock market it didn't drop as much. It dropped about 33%, but inflation increased by about 10.5% over the same time period. So this is a time period of four years. So over four years there was a negative real return of about negative 44%. So that's a long period of time for you to, on a real basis, lose almost half of your retirement purchasing power.
Speaker 1:Then, finally, the third event and I don't think this event gets enough focus or attention because this is actually much more recent was what he's calling the Big Bang, and that was from 1973 to 1974. That was a major recession and that one was the most devastating, as he explains, because it also occurred during a period of high inflation. So during this time period, over these two years, the stock market lost 37% of its total value. So over that 24-month time period and at the same time, inflation increased 22%. So over those two years, there was a real return of negative 59%, again, real return being your actual returns minus inflation. Well, if you have negative real returns and high inflation, you're now starting to dig yourself into a major dip here. So that was almost negative 60% real return over a two-year period of time, a very short period of time.
Speaker 1:Now here's what's really important to note about that. Are we going to have the exact same circumstances going forward? No, but as a retiree, what you want to be aware of is not can this withdrawal rate last in the best of times? Any withdrawal rate not any, but any reasonable withdrawal rate can last in the best of times. You want to know can your withdrawal rate whether it's 3% or 4% or 5% or whatever it is can that last in the worst of times? Can I continue to spend without making cuts and without paying for it in the latter years of retirement by withdrawing all my money before I'm done living?
Speaker 1:So let me now bring this all together as we look at those and why that's really important to note is when he came up with the 4% rule. So this was that first seminal paper that said the 4% rule is a safe withdrawal rate or the 4% rate is a safe number to use, because over a period of time, whether you go through the Great Depression, whether you go through that severe recession in 1973, 1974, even in the midst of that, with the portfolio allocated the way he talked about, which was a split of US stocks and US bonds, you were able to have your money last despite all of that. So, through those various circumstances, the 4% and where that came from is you saying 4% is the most that you could take and live through one of these scenarios and still have enough money in your portfolio to last for at least 30 years? So what does this have to do with Ben's question? Well, in a bit I'm going to get to three takeaways that we should walk away with from here. I know I'm not going to protect against sequence of return risk, but here's the first thing I would say is a lot of people might say, okay, I've heard of the 4% rule, I know I can take 4% per year out of my portfolio. But then they also assume that, okay, if 2008 happens or if 2022 happens, where the stock market loses 20% of its value, I'm probably going to have to make some cuts. Well, it might not be a bad idea, depending upon your situation, but assuming you're invested well and assuming you have a reasonable withdrawal rate which Bill Bangin talked about me, 4% being a reasonable withdrawal rate here then you might not need to. He's saying that, look, 4% you can take that, expecting the bad things are to come and you're still going to be okay. Using history as our guide, this in no way should be taken as a guarantee that this will continue forever, because we just don't know what's ahead of us. But if we look back on the last 100 years, it gives us some good context of okay, if 2008, fifties or 인�ve fiancee decided thatいい even some of these really horrible events in the stock market had you kept your withdrawal rate to 4%, it was almost as if not. It was almost as if it was as if you could maintain that withdrawal rate, live through that downturn and still have enough money in your portfolio to last for a 30 year time period. Let's look at a recent example to illustrate what I mean by that.
Speaker 1:2022 is not a fun year. A lot of you listening probably retired towards the beginning of 2022, or maybe retired recently before that. Well, the US market we're looking at the S&P 500, was down a little over 18% last year, and inflation, if we're looking at the consumer price index, was up about 18% year over year for 2022. That means you had a real return if you were fully invested in the S&P 500 of negative 26%. You were down 18 nominally. So the value of your portfolio plus. You were down another 8% because of inflation, for a real return negative 26.
Speaker 1:Last year was a very unpleasant year. Now keep that number of mine for a second. You were down 26%. Well, let's compare that to 1973, 1974. Over that two year period of time so it wasn't just a short 12 months, it was 24 months we're looking at you were down. Your real return was almost negative 60%, as we just looked at because of high inflation and a negative stock market downturn. Now, when we compare the two, if you think, oh, 2022, my portfolio is down. Therefore, I must take a cut. Not necessarily because remember that 4% rule says look, even if you were tired right before 1973, 1974, you could have taken the hit, survived the hit and still had your money last for 30 years and been just fine. 1973, 1974, that was a negative 60%, almost downturn.
Speaker 1:2022, we're looking at negative 26%, so not even half as bad as what we were looking at previously. So that's just a little bit of context, for as scary as some of these things feel and by the way they are scary, they're not pleasant. This is not what you want to retire into. We have to compare. What were things like when this research was done or what were things like that this research is based upon and if things worked, then it's not a guarantee that they work now, but it's at least some helpful. Context of this is more mild and, by the way, 2023 so far has been a positive year, and a quarter of this close to the end of the year, so very low likelihood that ends up as a negative year. You're going to not be guaranteed to be okay, but it looks as if this is much more mild than some of these really bad events that this research was based upon in the first place.
Speaker 1:Now I want to read directly from some of Bill Bangan's research in that white paper here for Ben, because, ben, he said this is particularly important for those of us wanting to retire earlier than normal retirees. Why does that matter? Well, in Bill Bangan's white paper he said, and I quote here assuming a minimum requirement of 30 years of portfolio longevity, a first year withdrawal of 4%, followed by inflation adjusted withdrawals in subsequent years, should be safe. In no past case has it caused the portfolio to be exhausted before 33 years and in most cases it will lead the portfolio lives 50 years or longer. So translation what does that mean? Well, what it means is, assuming you're invested the same way that Bill Bangin talked about being invested in his white paper. There's never been a case over this time period that we're looking at, that if you took 4% of your portfolio that it would not have lasted for at least 33 years. In most cases it lasted 50 plus years, essentially indefinitely. But worst case scenario, which is really what we're concerned about as retirees, is what if I retire and worst case scenario happens, 33 years was the worst case scenario of taking 4% per year out of your portfolio.
Speaker 1:Now, ben, you mentioned early retirement in your question. Everyone is different when they think of early. For some people that 60, for others is 45. So I've no idea how old you are, what your version of early retirement is, but what I will say is, for a lot of people who are retiring early, 30 or 33 years maybe isn't acceptable. If you retire at 45, 30 years only gets you to age 75. You're probably going to have a lot of life left after that. So how do we account for that?
Speaker 1:Well, bill Bangin addressed that, albeit a little bit indirectly. He said and this is another piece that I'm quoting from his paper he said it is clear that in absolutely safe to the extent history is a guide initial withdrawal level is 3% and that it ensures that portfolio longevity is never less than 50 years. This also is true for withdrawal rates as high as approximately 3.5%. However, most clients would find such a low level of withdrawals unacceptable. Now, I love that he added that on, because retirement planning is such a balance.
Speaker 1:If you came to me and said, james, I want to guarantee that I'm not going to run out of money, I would say it's easy, you just don't spend any of it. You're guaranteed not to run out of money. That's obviously a very extreme example and that's not the goal here. The goal is to say I want to balance not running out of money, but also still spending as much as I can to enjoy this money because I've worked hard for it and I want to use it to do the things that I want to do. So one of the factors that you have to look at is when are you retiring? How long do you need this money? How does your portfolio fit within the context of your overall financial plan? But this starts to provide some helpful context as we're coming to those decisions with our retirement plans.
Speaker 1:So, before we start to wrap up, I want to leave you with three things that you can do to protect against sequence of return risk, because a lot of people don't know what it is. Those that do know what it is sometimes maybe have an irrational fear of how severely it might hit them. So here's three things that you can take away. Number one this is what we spent the whole time talking about ensure your initial withdrawal rates are at sustainable levels. If you're taking 7, 8, 9, 10% per year out of your portfolio, I, too, have some pretty serious concerns about sequence of return risk. There's a high probability that you hit a little turbulence in the market and that withdrawal rate is not going to be sustainable for 30 plus years. However, if you're taking a more reasonable amount out of your portfolio I'll use 4% as an example and you're investing the right way and you're following the right rules, well, that's probably a pretty sustainable rate. Okay, none of this should be a guarantee or recommendation or in type of endorsement, but just using this white paper Bill Bangan's white paper as guidance and history as our guide, that should be pretty sustainable. So, number one make sure that your initial withdrawal rate is reasonable. That's the first thing that you can do to protect against sequence of return risk. The second thing you can do is ensure you have the right withdrawal strategy.
Speaker 1:Now here's a distinction I want you to make. There is a difference between a withdrawal rate and a withdrawal strategy. Your withdrawal rate might be 4% per year. Your withdrawal strategy is asking which specific accounts are we taking that 4% from and, even within that account, which specific investments are we selling or using to free up that cash? This gets more into another approach of the guidance guardrail approach I've talked about many times before of hey, maybe, instead of just putting all of your money into a portfolio and blindly taking it as you spend money in retirement, maybe you diversify further, and diversify very intentionally, such that ideally, year by year, you're only taking money from assets that have either gone up in value or at least have stayed stable. This means, in all likelihood, you're not taking proportionately from every single asset in every single account. More often than not, you might be pulling your money for the next year from the top performer in your portfolio in avoiding any withdrawals from the lowest performer in your portfolio. So make sure you have the right withdrawal strategy, which is different than your withdrawal rate.
Speaker 1:Number three, and this ties into it own the right type of assets. Every asset in your portfolio should have a goal. I'll give you an example cash horrible investment for long term. Great investment if you want to have some money set aside that you can draw from if and when stock values are down 20, 30, 40%. So how do you have the right mix of investments, some of which are going to deliver great long term growth but are going to come with a whole bunch of ups and downs in the short term, with other investments that aren't going to grow quite as much over time but are going to give you that stability and that protection of principle that you can live on in those years where the market's down 20, 30, 40 plus percent. Having that goes a long way in protecting against sequence of return risk, because it's insulating you from the downturns of the stock market, which isn't going to hit every part of your portfolio the same. So those are three things that you can do to protect against sequence of return risk and, in summary today, bend around out an answer to your question. Number one this goes for everyone. You need to account for sequence of return risk, not so much in your working years, because if you're not spending your portfolio it doesn't really matter, but you 100% must account for it in your retirement years. Number two a Monte Carlo analysis can be a very helpful tool to assist with this.
Speaker 1:You may have heard me before say I'm not a huge fan of Monte Carlo analysis as a financial plan itself. A lot of you might go to your financial planner and say, hey, how's our financial plan looking? They say you've got an 80% probability of success. That's not a financial plan. That's one gauge that helps you to understand your sensitivity to sequence of return risk or other risks that are present. Your financial plan is more, telling you here's what you need to do. That's just a gauge of how at risk are we. That being said, it is a very helpful gauge.
Speaker 1:Because what a Monte Carlo analysis is doing is it saying, going back to my financial planning example of modeling 6% out for the course of retirement, 6% growth that's not just assume you're going to get 6% every single year. I can all but guarantee you won't get 6% every single year. You might average it, but it's not going to happen every year. So what a Monte Carlo analysis does is it says okay, let's run a simulation of 1,000 or 10,000 different market environments using the unique return and standard deviation measures of each individual asset class in your portfolio. What if you retire and things are wonderful? Versus what if you retire and things are horrible? Let's run 10,000 different scenarios, modeling all kinds of different scenarios. What that does is it will say you've got an 80% probability, or 90% probability, of 30% probability of success being in 30% of the scenarios modeled this plan works, or an 80% of the scenarios modeled this plan works. That starts to tell you your sensitivity to sequence of return risk, among other things.
Speaker 1:And then finally, make sure that you understand historical context. Too often I hesitate to say this because I don't want people to say, oh, we shouldn't be worried about sequence of return risk. Yes, you absolutely should, but understand it within the context of what's happened historically. We saw three really negative circumstances the Great Depression, or the early Great Depression, the late Great Depression in 1973 and 1974, those were used as really horrible years in the market and said, okay, if these withdrawal rates, if these withdrawal amounts can hold up in those time periods not a guarantee that it can do so now as well, but at least provides some context. So when 2022 comes around and the portfolio is down 20% and inflation is up, it's not fun, but we have something to compare it to to say, okay, we've been okay in the past. It doesn't guarantee we're okay now. Certainly let's monitor this, but it's still well within what we might potentially expect from this type of a portfolio. So that is it for today's episode of Ready for Retirement. Ben, I really appreciate your question.
Speaker 1:By the way, if you're listening to this on the podcast, we're now recording these, so I used to just do the podcast and not record it. Now it's at least being recorded and thrown it up on the YouTube channel as well. So if you're listening on the podcast, tune into YouTube. The channel name is James Cannell. The handle is at root FP. Check it out there.
Speaker 1:Thank you, as always, to all of you who listen and I'll see you all next time. Hey, everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. This is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how root financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.
