The Sequence of Returns risk is the risk that the stock market is going to take a deep dive near the beginning of your retirement. Now, why does this matter if the stock market does well over the long haul? Imagine if you retired in October 2007. You’ve saved all your life for this and over the course of 18 months your retirement lost almost half its value.
For most folks, once you retire, you’ll need to start drawing income from your retirement and brokerage accounts thus a large drop in stock prices at the beginning of your retirement can put you in a hole that can be difficult to recover from. On the flip side, imagine you retired March 2009, over the next 10 years you’re up over 326%.
Here is a chart from bogleheads.org to demonstrate how it works. Using a $100,000 investment and withdrawing 4% for income, you can see the disaster that happens to Portfolio A which drops immediately in retirement. Down 29% in the first three years, this portfolio was never able to recover and runs out of money within 20 years.
If you flip the same returns with the negative 29% return at the end of 25 years instead of the beginning, Portfolio B starts off strong and stays strong. Even with the continued 4% withdrawal, Portfolio B is in great shape.
Comparing both portfolios, at the end of 25 years the compound growth rate is the same at 6%. That’s because the total return numbers are the same for both, the difference is whether or not you started in a big hole (Portfolio A) or started off with a tremendous gain (Portfolio B) in the early years.
What is the best withdrawal rate? The higher the withdrawal percentage that you take out, the higher the Sequence of Return Risk. 4% has been the rule of thumb for the past 30 years and anything over that amount becomes a bit risky. With that said, timing is everything. I’d suggest being willing to be flexible. If the markets are doing well, perhaps take a little more of the profit off the top. If the markets are down, then drop your withdrawal percentage and if possible, suspend your withdrawals until the markets start to recover. Looking again at Portfolio A, if you didn’t have a need to take an income withdrawal, the outcome would look a lot different. The portfolio would have recovered.
There isn’t a crystal ball telling us how the markets are going to perform when we retire. Therefore, it’s so important to do some planning and evaluate how much risk you are taking heading into retirement. Pulling back some of that risk in your portfolio and being ready to adjust your withdrawal amounts can help you avoid a disaster in retirement as well as helping you explore the right withdrawal rate for you.
Live free my friends,