An Avoidable Risk
One of the more commonly cited retirement financial risks cited is the notorious sequence of returns risk. This is a phenomenon where poor returns occurring early in retirement contributes to running out of money sooner even if overall returns during retirement are the same.
Take two investors, both of whom average, say, 6% overall returns over thirty years. This might be via one path where most years average 9%, but a couple of years of negative returns bring down the average. Both investors begin by withdrawing 4% of their nest egg in the first year of retirement and adjust the withdrawals by “inflation” (eg as determined by the CPI) thereafter. This is the popular “4% rule” widely cited by advisors as a safe drawdown strategy.
Why does the order in which the same overall returns occur matter? The large withdrawals early in retirement force sales at low prices and deplete capital faster than they would if they occurred late in retirement.
But is it the markets or the investor that produces this asymmetry? Neither. It’s the fault of the withdrawal plan.
It’s the result of lack of feedback, a withdrawal strategy that looks at the market value of the portfolio just once – at the very beginning – and then never looks again. In short, it is a flaw in the withdrawal strategy, not the investor or the markets, that produces the risk. If poor returns occur soon after starting, it may just mean you took that just one look near a market peak.
What if, instead of taking one snapshot of the portfolio value and basing decades of subsequent behavior on it, we checked in every year? Instead of adjusting the withdrawal with a government statistic we just withdrew 4% of whatever the portfolio value is at that time?
Remarkably, sequence of returns risk vanishes. A large drawdown in the markets has the same effect regardless of when it occurs, courtesy of the basic mathematics principle known as the commutative law. The order in which returns occur don’t matter.
What’s more, the risk of running out of money vanishes along with it.
The amount of the withdrawals may decline, however, if the chosen percentage is higher than the rate of return. For an appropriately diversified portfolio, 3% is more likely to keep withdrawals apace with inflation. To produce a stream of income that keeps pace with inflation, and never runs out, forget the 4% rule. Withdraw 3% of the portfolio value each year.