Sequence of return – or sequence risk -can pose a serious threat to you portfolio and is a factor to be very aware of and take measures against when you are planning your retirement. Sequence of return can hamper a secure retirement, whether you plan to retire when you are 40, 65 or 80 and it can seriously increase your chances of outliving your portfolio, meaning you might be left with no income towards the end of your retirement.
So what is sequence of return?
Sequence of return is the risk of your portfolio being hit by bad market returns early on in retirement when you start making withdrawals from your portfolio. Like for anybody a bad market return affects the value of your portfolio, but whereas you have time to recover from a few bad years if you are still building up your portfolio, once you start withdrawing you no longer have this time to recover. The value of the portfolio can be affected (i.e. decreasing) by it so much that it threatens its own chances of survival. Not only does your portfolio reduce in value from your withdrawal but also from the market drop.
Let’s have a look at how devastating this effect can be by looking at the portfolio of a retiree who is hit by this phenomenon Let’s say they have $1,000,000 and that the market returns an average of 8% over the first 20 years. This retiree takes out $40,000 (4%) in their first year and then adjust for inflation by 3% each year. Below is the chart with how well they do.
|market returns||start portfolio||take out||Total left over|
|-10%||$ 1.000.000||$ 40.000||$ 864.000|
|-15%||$ 864.000||$ 41.200||$ 699.380|
|-25%||$ 699.380||$ 42.436||$ 492.708|
|5%||$ 492.708||$ 43.709||$ 471.449|
|0%||$ 471.449||$ 45.020||$ 426.429|
|-15%||$ 426.429||$ 46.371||$ 323.049|
|5%||$ 323.049||$ 47.762||$ 289.051|
|20%||$ 289.051||$ 49.195||$ 287.827|
|10%||$ 287.827||$ 50.671||$ 260.872|
|25%||$ 260.872||$ 52.191||$ 260.852|
|30%||$ 260.852||$ 53.757||$ 269.224|
|15%||$ 269.224||$ 55.369||$ 245.932|
|-10%||$ 245.932||$ 57.030||$ 170.012|
|15%||$ 170.012||$ 58.741||$ 127.961|
|25%||$ 127.961||$ 60.504||$ 84.322|
|30%||$ 84.322||$ 62.319||$ 28.604|
|-15%||$ 28.604||$ 28.604||$ 0|
|15%||$ 0||$ 0||$ 0|
|30%||$ 0||$ 0||$ 0|
|25%||$ 0||$ 0||$ 0|
Despite the average 8% return, as you can see, this portfolio takes a big hit at the start of retirement with big negative returns and therefore a big decrease of value early on. Unfortunately after 16 years this person has run out of money and is no longer able to draw anything out of their portfolio. Of the $1,000,000 they started with, they were only able to take out just over $806,000.
Let’s look at a second example of a person who also starts with $1,000,000 when they retire, takes out 4% in their first year as well, readjusts for inflation by 3% each year and although experiences the very same market returns, with an average of 8% over 20 years, sees the order of these market returns completely reversed.
|start portfolio||take out||Total left over|
|25%||$ 1.000.000||$ 40.000||$ 1.200.000|
|30%||$ 1.200.000||$ 41.200||$ 1.506.440|
|15%||$ 1.506.440||$ 42.436||$ 1.683.605|
|-15%||$ 1.683.605||$ 43.709||$ 1.393.911|
|30%||$ 1.393.911||$ 45.020||$ 1.753.558|
|25%||$ 1.753.558||$ 46.371||$ 2.133.984|
|15%||$ 2.133.984||$ 47.762||$ 2.399.155|
|-10%||$ 2.399.155||$ 49.195||$ 2.114.964|
|15%||$ 2.114.964||$ 50.671||$ 2.373.937|
|30%||$ 2.373.937||$ 52.191||$ 3.018.270|
|25%||$ 3.018.270||$ 53.757||$ 3.705.642|
|10%||$ 3.705.642||$ 55.369||$ 4.015.300|
|20%||$ 4.015.300||$ 57.030||$ 4.749.923|
|5%||$ 4.749.923||$ 58.741||$ 4.925.741|
|-15%||$ 4.925.741||$ 60.504||$ 4.135.452|
|0%||$ 4.135.452||$ 62.319||$ 4.073.133|
|5%||$ 4.073.133||$ 64.188||$ 4.209.392|
|-25%||$ 4.209.392||$ 66.114||$ 3.107.459|
|-15%||$ 3.107.459||$ 68.097||$ 2.583.457|
|-10%||$ 2.583.457||$ 70.140||$ 2.261.985|
This person far outlives their portfolio and although they start to take hits towards the end of the 20 year time period, their portfolio is still more than doubled from what they started with. In addition, they have been able to take out more than $1,074,000 and still have a lot left over in their portfolio.
Of course this is all a matter of luck of how well your portfolio survives from the moment you retire, and there isn’t much you can do about these market returns. What you can do however is changing your retirement strategy in order to ensure that you don’t outlive your portfolio.
Strategies to combat Sequence of Return
If you are able to delay your retirement age and start withdrawing from your portfolio just a few years later this could have a huge impact. In the example above of the first retiree, if they had held off withdrawing from their portfolio just 3 years (and without even continuing to make extra contributions), their portfolio would have fared a lot better and they would have ended up with over $563,000 20 years later, i.e. 17 years into retirement, which is a lot more than what they had in the example above!
Adjust your withdrawal amount
Adjusting the withdrawal amount depending on the value of your portfolio can have incredible impacts on the portfolio. Looking again at the first example if the person had adjusted their withdrawal rate to 4% of the value of the portfolio all along, they would have ended up with more than 1,5 million after 20 years:
|start portfolio||take out||Total left over|
|-10%||€ 1.000.000||$ 40.000||€ 864.000|
|-15%||€ 864.000||$ 34.560||€ 705.024|
|-25%||€ 705.024||$ 28.201||€ 507.617|
|5%||€ 507.617||$ 20.305||€ 511.678|
|0%||€ 511.678||$ 20.467||€ 491.211|
|-15%||€ 491.211||$ 19.648||€ 400.828|
|5%||€ 400.828||$ 16.033||€ 404.035|
|20%||€ 404.035||$ 16.161||€ 465.448|
|10%||€ 465.448||$ 18.618||€ 491.513|
|25%||€ 491.513||$ 19.661||€ 589.816|
|30%||€ 589.816||$ 23.593||€ 736.090|
|15%||€ 736.090||$ 29.444||€ 812.644|
|-10%||€ 812.644||$ 32.506||€ 702.124|
|15%||€ 702.124||$ 28.085||€ 775.145|
|25%||€ 775.145||$ 31.006||€ 930.174|
|30%||€ 930.174||$ 37.207||€ 1.160.857|
|-15%||€ 1.160.857||$ 46.434||€ 947.259|
|15%||€ 947.259||$ 37.890||€ 1.045.774|
|30%||€ 1.045.774||$ 41.831||€ 1.305.127|
|25%||€ 1.305.127||$ 52.205||€ 1.566.152|
Although as you can see this means there are certain years when the person can only withdraw a meager $16,000, this portfolio at least survives and provides some income all along. In total they still managed to withdraw just under $600,000, i.e. 75% of what the first person withdrew.
Rely on cash during low returns
Avoid withdrawing from your portfolio during low market returns, for example by relying on cash reserves during tougher times. Having some of your savings tucked away in a savings account instead of in an investing account means that you don’t need to worry about market crashes and this can be a safe way to avoid depleting your portfolio faster than you want. This strategy can easily be used alongside the adjust the withdrawal rate option so you needn’t even rely on cash completely. Of course any money sitting in a savings account might not make you any money if it isn’t receiving a lot of interest and probably even loses value over time due to inflation, so you don’t want to keep way more than you need there either.
Have other income streams
Supplement your withdrawal from your portfolio by other income streams such as a pension or annuity. Depending on when your pension starts kicking in this might be at exactly the right moment but if you retire before the official retirement age, you might not receive any pension for another couple of years. If you can rely on annuity in the mean time this might give you the option to ride out the low returns until you can start withdrawing more from your portfolio again. Of course having other sources of income such as rental income or profit income can also provide an excellent alternative to withdrawing from your portfolio.
This has been mentioned many times before but by diversifying you don’t get affected by lows as much as you don’t just rely on stocks but on other assets classes as well. So even if your shares portfolio drop by 20%, your bonds might still be holding up or maybe you can start withdrawing a little more from your gold supply. Depending on which assets have performed better (or less worse) you can adjust the part of your portfolio that you are withdrawing from thereby avoiding liquidating your losses.
Step 97 – Sequence of Return – in detail:
- Plan for the possible risk of sequence return on your portfolio during your early retirement years by implement several of the options described earlier into your long-term financial plan:
- Be flexible with your retirement age. Of course you can have a goal to retire at a certain age or date, but remember it might be worth considering retiring one or two years later if it means your portfolio stays healthy and your retirement secure.
- Prepare for a flexible income. Pay off as many of your debts as soon as possible so you don’t need to pay off anything when retired, this includes your mortgage. Design a lifestyle in which you can easily cut costs, i.e. by cutting holidays or luxury retreats during your retirement. In that way it will be a lot easier to aim for a 4% withdrawal rate even if that means a significant reduction in your income from one your to the next.
- Decide how much cash reserves you’d like to have and might need and decide how and when to start building this up.
- Build up other income sources:
- Make sure to build up enough pension
- Consider getting (several) annuities
- Develop other income streams aside from your income, that might still give you an income by the time you retire.
- Diversify your portfolio and invest in various asset classes: stocks, bonds, real estate, gold, commodities as well as across markets: national, international, emerging markets, small cap and large cap etc.
- Start de-risking your portfolio closer to retirement age by increasing your percentage in bonds and decreasing the amount of shares you own.
Whether sequence of return will be a factor when you retire or whether you are lucky and experience good returns at the start of your retirement you won’t be able to predict. But what you can do is prepare yourself as best as you can in case you are unlucky early on in your retirement. Come prepared and avoid running out of money early on in your retirement.
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.