The Retirement Torpedo - Sequence of Returns Risk
Mark McGrath, CFP?, CIM?, CLU?
I help Canadian physicians treat financial uncertainty.
There’s a hidden danger, lurking in the shadows, waiting to ambush your retirement plan.
What is it?
It’s called “sequence of returns risk”, or SORR for short.
Here’s how it works, and how to catch it before it pounces.
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Imagine this -
2 people:
1 runs out of money, the other dies with more than they started with.
Huh?
How?
SORR, of course.
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What is SORR?
It's arithmetic.
When you add to, or withdraw money from a portfolio, the order of the returns you earn has a significant impact on your portfolio value over time.
In retirement, withdrawals in a down market act as a weight, pulling your portfolio down further and making it harder to recover.
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Say you have a $1M portfolio and withdraw $50k per year. Over the course of two years, your portfolio goes up 50% in one year, and down 50% in the other year.
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Scenario 1:
You earn the positive return the 1st year, and the negative return the second year.
End value = $675k
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Scenario 2:
You earn the negative return the 1st year, and the positive return the second year.
End value = $625k
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That difference of $50k?
That’s SORR in action.
And when you compound that over many years, you end up with something like this:
If you get unlucky and retire into a bad sequence of returns, then assuming a constant, inflation-adjusted withdrawal rate - your withdrawal rate as a percentage of your remaining portfolio goes parabolic.
You need to withdraw a higher percentage of the remaining value:
Most of the risk centers on the years just before and just after retirement. That’s the danger zone, when SORR has an outsized effect on the sustainability of your portfolio.
In fact, the return you earn in the 1st year of retirement can explain a whopping 14% of your outcome!
You can model this using a Monte Carlo simulation.
Instead of using historical returns, it uses assumptions about expected returns and volatility.
And the outcome can vary wildly.
Notice the range of outcomes even if you cut out the top and bottom 25% of outcomes:
You can also look at it on a per-year basis.
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Running 1000 different trials, you can see how many of those trials each year were successful, and how many times the simulation ran out of money:
Great.
So now you know it might easier to run out of money than you thought.
What can you do about it?
A few things:
1. variable spending
2. access buffer assets in bad years
3. risk pooling/annuities
4. de-risk your portfolio
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Let's look at each:
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1. Variable spending
There are a few different strategies, but the concepts are similar.
Rather than draw a constant, inflation-adjusted percentage, you vary your spending based on performance.
Markets down? Spend less.
Markets up? Spend more.
Easy to say, harder to do.
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2. Buffer assets
Being able to skip portfolio withdrawals during periods of bad returns can potentially eliminate SORR.
Buffer assets can include:
Note each of these comes with its own pros and cons.
3. Risk pooling/annuities
An annuity is an exchange of capital for income.
It's like buying a pension.
It transfers the risk from your portfolio to an insurance company, providing you with a known, permanent amount of annual income instead of an unknown and variable one.
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4. De-risk your portfolio
Volatility can exacerbate SORR.
By reducing volatility and stabilizing returns, you reduce SORR.
Consider holding more fixed income like cash, GICs, or bonds, especially in the years immediately before and after retirement.
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Sequence of returns risk can torpedo your retirement.
By understanding how it works, and what you can do to defend against it, you can decrease your chances of outliving your money.
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Resources:
Most of the information and charts from this thread come from these papers by Dr. Wade Pfau:
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Monte Carlo illustrations done with Conquest Planning software.
Want to run your own? Check out this free tool from Honest Math: https://www.honestmath.com/
Teacher / Instructional Technology / eLearning /Actor / Director
1 年Honest math is American. How does it work with Canadians.
Author & Financial Independence Coach- Financial Education for Expats
1 年Great article! A stock market crash on the day of retirement can break your retirement plan if you follow rules of thumb to the letter. Is it then sensible for investors to only sell (SWR) the bonds part of their portfolio during down years?
Principal, David Cooke Wealth Counsellors Inc.
1 年Ah, that little nasty gremlin ….
I love that you've addressed this - it's not discussed enough! Often clients prefer to keep their risk higher than necessary around retirement time in the hope of better returns without understanding how impactful a bad year can be. Very well explained.