Below is an excerpt from the book Downsize Sooner than Later – 18 Rules for Retirement Success available on Amazon.com.
This appendix is about a particular risk inherent in portfolio-based retirement income plans called the “sequence of returns.” I considered including it in the rules, but it can appear a bit technical to some, so it seemed better as an appendix.
This risk is derived from the impact of making regular withdrawals from an invested retirement portfolio for income purposes over time.
It is uncontrollable, unpredictable, and can be difficult to detect, even when one is entrapped within its gradually closing jaws. With disturbing frequency, this risk leads to the eventual depletion of retirement funds. This depletion, being unhurried, often delivers its most devastating blow at the worst possible time – in late and vulnerable retirement years.
Astonishingly, few investors seem to be aware of this risk. I find this fact stunning. It should be posted like a warning label all over retirement planning literature, yet little seems to be said about it. For your own protection, I encourage you to familiarize yourself fully with the fundamentals of the sequence of returns risk. For your own benefit and for others, I challenge you to learn it so well, you could teach it.
So, here goes…
Let’s begin by dealing with the most difficult concept and that is defining what is meant by a “sequence.”
If I were to serve you a three-course meal, it might go in the order of: salad, followed by main course, followed by dessert. However, if I change the order – or, the sequence – it might go: dessert, followed by main course, then concluding with salad.
Regardless of the differences in the two sequences, the same “average” meal is served. It has the same average weight, the same average calories, the same average nutritional value, etc. It may seem unconventional in the second example for dessert to come first, but even so, it doesn’t change the fact that the average values remain 100% the same.
Just like with a meal, it is possible that when two people invest or retire at differing times – they may experience similar average returns over time, yet the experience of those returns may appear in differing sequences.
For example:
- Sally retired and started making income withdrawals in a year the market was down -13%.
- Bill retired and started making withdrawals in a year the market was up 7%.
- Francis retired and started making withdrawals in a year the market was up 27%.
The three numbers representing initial retirement investment returns for Sally, Bill, and Francis above are as follows: -13%, 7%, and 27%. Add them up and you get a total of 21. Divide 21 by 3 and you get an average of 7%. This is called an “arithmetic average.”
Similarly, the often quoted “7% inflation adjusted rate return of stocks including dividends” is an arithmetic average. This arithmetic average is frequently used by planners as a waypoint to help determine appropriate portfolio-based income withdrawals during retirement.
Just like with the meal, you can add the three numbers above together in any “sequence” you want, and you’ll still get a total of 21 and an average of 7%.
-13 + 27 + 7 = 21. (21 divided by 3 = 7%.)
7 + -13 + 27 = 21. (21 divided by 3 = 7%.)
27 + 7 + -13 = 21. (21 divided by 3 = 7%.)
But, here’s the rub…
Unlike the order of the entrees served at a meal, the order in which these numbers appear as returns in a person’s portfolio-based income retirement plan can have a major impact on how long his or her portfolio lasts during retirement.
Let’s look at a test case.
Using the rates of return listed above: -13%, 7%, 27%, we will apply returns in different sequences to a portfolio funding systematic withdrawals – just as would be the case for an individual funding his or her retirement.
To keep things simple, we’ll start with a $100 nest egg and take $10 out of the portfolio each year to pay bills. Both examples below experience the same 7% average return over time. The only difference between the two scenarios is the sequence in which the returns occur.
In Sequence One, Sally’s order of returns are:
• -13% in year one.
• 7% in year two.
• 27% in year three.
These returns will continuously repeat to yield an ongoing average return of 7%.
In Sequence Two, Francis’ order of returns are:
• 27% in year one.
• 7% in year two.
• -13% in year three.
These returns will continuously repeat to yield an ongoing average return of 7%.
Let’s see what happens…
Looking at these two charts, what lessons do we learn?
Sequence Two ends up yielding 44% more income than Sequence One (i.e. $168.37 versus $116.81) and lasts five years longer. That this happened is blind, random luck and beyond the control of presidents, cable-news commentators, celebrity endorsements, economists, financiers, prognosticators, financial advisers, the media, and the roar of the crowd.
Further, it happens with the same $100 nest egg, the same rate of withdrawal, and the same long-term average rate of return. The only difference is the unpredictable and uncontrollable order or “sequence of returns”.
You can create examples of these sequences ad nauseam.
The results will inevitably show that the difference in the order of returns – especially more negatives in early years, either just before or just after retirement begins – can have a dramatic impact on how long a person’s retirement funds will ultimately last.
Can you imagine how many people went broke before this issue was identified and called out? Can you imagine how many more are going to go broke, having never had it explained it to them? Note again also…women are generally put most at risk because on average they live longer.
It is a very difficult situation and an unintended consequence of the shift from defined-benefit retirement income funding (i.e. pension, pooled income models) to self-directed defined-contribution-based retirement income funding (i.e. 401(k), IRA, portfolio-based income models).
Some get off swimmingly, while others crash and burn – all in a roll of the dice.
But, again, it doesn’t have to be this way.
Especially for those feel they will live longer than average, the solution is clear and is woven into the prior rules presented on this blog.
Notably:
- Accept you will always have bills to pay. (Rule 1)
- Lower and control your ongoing expenses. (Rules 2, 4)
- Downsize as soon as possible. (Rule 3)
- If possible, delay Social Security to age 70, thereby maximizing it. (Rule 10)
- Separate your income from your wealth. (Rule 5)
- For income, arrange to pay your basic ongoing bills with ever-replenishing, non-stock-market-dependent, pooled income. A dollar from portfolio savings used to pay a bill is gone forever. But a dollar from pooled income used to pay a bill lasts a lifetime. (Rule 6)
- For wealth, plant a money tree and don’t disturb it. It will be ideally situated to benefit from future averages rather than be punished by them. This remains true, regardless of their sequence of returns over time. When the market goes up or down, forget about it. Instead, go have lunch with a grandchild, paid for with funds you received from pooled income. (Rule 7)
- Where possible, stay economically productive. This supplements your income, allows you to add “fertilizer” to your money tree, keeps you sharp, reduces stress, promotes positive social connections, and gives you more funds to enjoy. (Rule 11)
- Have adequate insurance. Plan for long term care to protect your wealth and the safety of the people who care about you the most. (Rule 9)
Questions or comments?
I can be reached at this link – contact Ted Stevenot.