The Horseman of Sequence of Returns

February 1, 2022 5 Minute Read

 This month the risk I want to talk about a bit is Sequence of Returns.  Which sounds ominous, and it is, but it is relatively simple and essential to understand. 🏇

Two scenarios face our clients Mary and Bob.

Mary accumulated a nice nest egg, planned carefully, and began a reasonable withdrawal rate from her retirement savings.  You may ask, what’s a reasonable rate? Recent Barrons article here for that discussion, and we’ll say 4%?  Mary was also fortunate about the time she chose to retire.  She began retirement during a bull market and enjoyed positive returns for more than 10 years following her retirement.    We will say she retired in 2012, with a portfolio of 60% stocks and 40% bonds, and enjoyed a 15% return on her stocks and 2.5% on her bonds for a blended return of 10%.  WARNING! Back down math nerds and investment historians. These are approximations of returns Mary might have experienced.  They are not intended to provide exact math on the above.  This is just to illustrate the impact of sequence of returns.

Bob was less fortunate.  He also planned well and accumulated a healthy nest egg and began withdrawing as Mary did – but the timing of when he made the withdrawals was not as fortunate.  He began in January 2001, and by the end of 2010 his stock returns were essentially flat (even with dividends), though his bonds did better, at say 4%.   With the same 60/40 stock bond portfolio, his return was about 1.6% for the decade… and all the while he was taking out 4% each year.  With inflation and a nearly flat growth rate of his assets, he depleted over 1/3 of his nest egg in the first decade.  (Again, these are approximations for illustration.)

But it gets worse. Had Bob retired just 10 months earlier, on March 24th of 2000, at the S&P’s peak, he might have seen his stock portion drop by 47% before recovering (or a 28% loss in a 60/40 portfolio).  (Approximations again.)

OK, enough of the doom and gloom thought experiment. What do we do about it?  Here are some ideas.

  • Make reasonable assumptions about rates of return.  Seriously, there are lots of websites out there that will let you plug in 15% rates of return, and this is just not reasonable.
  • Be willing to take a bit less income in down years.  This strategy takes a bit of work and we are happy to help.  See the Barrons article above.
  • Save more than you think you need.  A margin of error here of 30% would be great.
  • Determine the rate of return you need to meet your needs and design a portfolio for that risk level.
  • Have streams of income that are not dependent on the stock and bond markets.
    • Social security
    • Annuities, the simple ones, for a portion of savings, not the ridiculously complicated ones you see at the free steak dinner.  Please avoid these!
    • Rental property
    • Business

Stories like Mary’s and Bob’s are why I always encourage clients to reach out for zooming or chatting and connecting.  These conversations are the perfect opportunity to discuss any concerns you have and make sure you’re comfortable with your progress preparing for financial independence.