Step 97: Sequence of Return

Step 97 of the 100 Steps mission to financial independence: Sequence of Return
Step 97: Sequence of Return

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. Continue reading

Step 42: State Pensions

Step 42 of the 100 steps mission to financial independence: State Pensions
Step 42 of the 100 steps mission: State Pensions

In the previous step we looked at the different types of pensions that exist. In this step we look at state pensions in detail, although many of the characteristics of state pensions also apply to other types of pensions. Pensions vary greatly from one country to the next, if they even exist at all, as not all countries offer state pensions, so make sure to do your homework well and read up on the details of the state pension for your country.

If you are entitled to a state pension this is normally regardless of the height of your salary and of any workplace or private pensions you might or might not have. Bear in mind that most state pensions tend to be far from generous and designed mainly to just provide for your basic needs.  Continue reading