Sequence of Returns Risk: How You Can Manage Its Impact on Your Retirement Portfolio

If you’re in retirement or soon to be in retirement, one of the biggest risks that you face is called sequence of returns risk. Now, when I do public speaking events and I ask the audience, how many of you have heard sequence of returns risk? Maybe two, three, four hands will go up, and if I ask them, where’d you hear it from? A lot of them tell me they heard it from my channel here on YouTube. What is sequence of returns risk? It’s the combination of losing money and taking withdrawals from your portfolio.

This combination or dual effect has essentially a negative compounding or downward spiraling impact on your portfolio. That means that you could potentially run out of money much sooner than otherwise if the market had gone up or you had made money in the beginning years of retirement or leading into it. This is a very important concept for you to understand entering retirement or if you’ve just recently retired. It’s also good to know that if you’ve been retired for some amount of time, you’ve essentially shortened the time frame that your money needs to last, and therefore, each passing year, sequence of returns risk becomes less and less of a threat to your family’s security.

We’re going to talk about the importance of balancing risk versus reward and identifying the proper growth rate that you need to achieve your income goals, maintain your spending desires, and also keep up with inflation. Then also we’re going to talk in a high level how to mitigate sequence of returns risk in the third part of today’s video.

The Impact of Sequence of Returns Risk on Retirement

Sequence of returns risk is really a series of events that happens to you if you’ve not prepared. Ultimately, it’s retiring with bad timing. I want to first set the stage, show you a couple of different examples where, one, we retire in positive years, and then flip those returns around and show the negative ones at the end, at the beginning. Then I also want to show you an example of how retiring before a certain run in the market, so the year 2000 to 2009, and then 2010 to 2019, if you retired in those two different time frames, how the market returns were entirely different in your retirement. Your security, your income could be jeopardized simply by the year that you retire.

Here we have some hypothetical returns. Feel free to pause the video if you want to look more closely at the chart. We have a 22-year period here, 23-year period, average returns of 8.5%. Starting with $500,000, withdrawing $24,000, and increasing with inflation, before inflation over the course of this retirement period. Then 20 years later, after taking $730,000 of income from this portfolio, remember, starting at $500,000, we have $1.327 million left. Pretty successful retirement. This would be good returns in a portfolio or a positive sequence of returns experience.

Now, if we take these negative returns and then flip them around to where they occur in the beginning years of retirement, this is what we get. We have the same average return, 8.5%, the same total withdrawals, but because the returns were negative in the beginning, we end up running out of money in about year 20 here. We actually have a shortfall of $154,000. Nothing has changed. We just flipped the returns upside down. One thing to also point out here is that 6 years, the rest are positive. Only 6 years are negative throughout this entire hypothetical scenario.

Many of you, probably all of you, if I told you over the next 23 years we’re only going to experience 6 bad years in the market, you’re going to average 8.5% annually. Would you take that if you could make that decision leading into retirement? I bet 100% of you would say, “Yes, Troy, we would sign up for that immediately.”

The second part of that question, though, is when do those negative returns occur? In this example, we quite clearly see that even when we have these really big numbers in the back end, 13%, 11%, 21%, positive 31%, 18%, 28%, even when we have those big numbers in the back end of the plan, it’s not enough to salvage what happened in the beginning. The hole we dug was too deep.

Understanding Retirement Income Needs

Now here’s the story of two different sisters. One retired in the year 2000. The other retired in the year 2010. $500,000 saved at retirement. They’re going to withdraw $30,000. Jane retires in 2010. Jill retires in 2000. Here is the retirement in 2010. This is the S&P 500, but again, this is for illustrative purposes only. Past performance isn’t indicative of future results. Just using this to educate regarding sequence of returns risk and showing the account starts with $500,000. We have positive sequence of returns here. 10 years later, that $500,000 has grown to $874,000, and we’ve taken $300,000 out of the portfolio.

The second sister, who retired previously in the year 2000, heading into the market crash from the dotcom bubble in the late ’90s, we see here negative sequence of returns in the beginning, same $500,000, withdrawing $300,000 over the first 10 years of retirement. She’s left with $96,000. Two completely different experiences solely based on the time of when you retired.

If you’ve heard me say it once, you’ve heard me say it 1,000 times. Retirement is no longer about accumulating a nest egg. It’s about properly distributing that nest egg. We have to balance risk versus reward. If you think of a seesaw here, if you have a person that’s much heavier on one side and someone, maybe a child, who’s much lighter on the other, you don’t have much of a seesaw action there. There’s no balance.

Sometimes when I want to unwind and I come home after a long day, I like to turn on Beat Bobby Flay. It’s just amazing to me that he can beat executive chefs with their own signature recipes or signature dishes without sometimes having ever cooked it in his entire life. It’s because he knows flavors and he understands how to balance them out with one another to make something that tastes incredibly delicious. When we transfer that concept over to building a portfolio in retirement, we still need that balance.

The two components that we’re trying to balance, though, is risk on one side of the seesaw and your growth rate or expected growth rate on the other side. We don’t want to take so much risk that we could potentially fall victim to the sequence of returns. We also don’t want to take too little risk to where we don’t have enough growth potential to achieve our long-term income goals. We need to find that balance.

Factors Affecting Risk Tolerance and Capacity

That balance is actually defined by two things. One, your willingness to stay invested through a market downturn, meaning if the market goes down, are you panicking? Are you calling us up and saying, “Troy, get us out of the market?” Or you say, “You know what? I’ve been through this before. I have the proper tools in place. I have a strategy. I have a plan that I’m connected to. I can log in. I can see where I’m at, how this is impacting me, and I can stay the course.” That’s your risk willingness.

In the industry, it’s known as risk tolerance, but I like willingness because it’s how willing are you to stay committed to the plan that’s been put together. The second one is risk capacity and it just simply means based on your income need, the amount of money you have to withdraw, let’s say it’s 7%, and you really want to enjoy your money. You don’t plan on living a very long time. If you have a higher distribution rate, you have a lower capacity for risk because if things go against you, a sequence of returns really can bite you in the butt because if you suffer big losses while taking big distributions, you’ve basically shortened the life expectancy of your portfolio significantly.

Here’s one of the tools that we use and I like this tool for a couple of reasons. One, it defines risk in terms of dollars. A long time ago, I sat with someone and he said, “Troy, I’m fine losing 10% in a market crash or a recession.” We were going to build a portfolio that mathematically had that range where it was expected to never lose more than 10%.

Just to make sure we were clear, I like to repeat things back so I understand them and we’re both on the same page. I said– He had $2 million. “If you lose $200,000 in the next market pullback or correction, you’re going to be okay with that?” He said, “No, Troy, I’d fire you instantly.” I like this tool because we can really dive into your willingness to stay committed to an investment strategy within a retirement plan based on potential dollars lost in a recession. I want to dig through this with you now.

Tools for Analyzing and Mitigating Risk

Here we have a standard 60-40 portfolio. 60%, this is the S&P 500, and 40%, this is the AGG, the AGG, and it’s just a high-quality investment grade corporate bond index. Combined risk of this portfolio is 54, and that’s on a scale of 1 to 99. Here we see, based on the historical performance of these two financial tools working together as ingredients in a recipe, now we’re starting to look at the correlation of these two assets melded together. What is the probability of performance over the next six months? We receive it here in dollars and percent. 95% probability that over the next six months, this portfolio will not lose more than 10.5% or $106,000.

Now, extrapolate that out over the course of a year. We’re looking at a 20% decline in $212,000 in actual money lost. Now, this is on a $1 million portfolio. The first question I would ask to you is, if we go into a recession or if the market pulls back, are you comfortable seeing your accounts reduce by $200,000? Let’s say it’s your first year, your second year, your third year, your 10th year of retirement. This is how we really identify your willingness to stay committed to an investment plan. Because we can put together an amazing tax strategy, an income plan, all of this could be just what you want, but if you don’t stay committed to the investment strategy, everything else blows up.

The first part is the risk component. Are you willing to take this level of risk and stay committed to a financial plan? Remember the seesaw, we have to balance out risk for expected growth. This is a consensus essentially of different experts out there, investment banks, forecasts that are put out. The consensus of 5.25% annual return for this 60-40 portfolio.

Interesting note, Vanguard just recently put their forecast out for equities over the next 10 years. I believe it was Vanguard, could have been Morningstar, but it really made news in the financial industry because I think it was around 4% or 5% was the projected growth rate of equities over the next 10 years. Now that’s just one of dozens of investment banks and institutions that put these forecasts out, but it did create some hubbub on social media, and if you Google it, you can probably find that article.

The question is, can you achieve your spending goals in retirement, keep up with inflation, possibly gift money to kids or grandkids, charitable causes, buy that summer home, or just vacation in different Vrbos or Airbnbs, is this enough growth to achieve the goals that you have in retirement? We can quibble over whether equities are going to perform X percent or bonds.

The truth of the matter is, most of these forecasts are pretty inaccurate, especially when it comes to equities over long periods of time. The longer you project out, the less accurate that you become. The goal with this video is to simply help walk you through and help you to understand how we look at balancing risk-reward to mitigate sequence of returns risks so we can build an income plan that helps you maintain your quality of life, standard of living as you progress through retirement.

Stress Testing Retirement Plans

It’s always important when we’re doing a retirement risk analysis of your portfolio to stress test it. First and foremost, if we had a bull market 2013, how would this portfolio perform? You could expect to be up around 16.5% or $167,000. If we had a bear market like 2008, we would expect this portfolio to lose about 17% or $173,000. The financial crisis, again, this was 2007 to 2009, and it was about an 18-month period, $272,000 or 27% down. These are two more relevant scenarios because we just went through these. In 2020, we had the pandemic crash. We’d expect this portfolio to lose about $178,000, and then the inflation crash.

This was 2022. The year ended up down, this would have been about 16.3%, but it’s important to point out that in 2020 specifically, remember, that was a V-shaped. Even though this portfolio would have lost 17.8% from a point-to-point basis, really, if you were looking at it in March or April, you were probably down significantly more. The question becomes, is your investment strategy or how you’ve allocated your money, are you willing to stick with it in a period of volatility and unexpected market declines?

Now, we’re going to bring this back to a chart that you guys are probably familiar with. We went through all those first steps of balancing risk versus reward. Now we’re starting to see, do you have enough money? Will your income last as long as you do? That’s where we’re starting to run this retirement income analysis, where we’re saying, based on the portfolio, how much income you need, the longevity, we’re looking at a little more than a 25-year retirement here, this comes out to about 78%.

If that’s the case, do we need to take more risk? Do we need to take less risk? Do we need to adjust the spending? Maybe we need to create a go-go plan and then a slow go, where we’re spending a little bit more for the first 4, 5, 6 years of retirement, maybe not for 10, looking at all these different variables. We also want to stress test the retirement income plan. We do that by looking at the impact sequence of returns could have. Here we have the green line, which assumes, remember that was 78%. That means 780 out of 1,000 Monte Carlo simulations, you pass away with money.

In some of those simulations, 22% of them or 220, you don’t. You run out of money before you run out of life. That’s what we all want to avoid. This red line here is simply showing what happens if we have bad timing, if we have sequence of returns risk. Average for the entire plan is about 6.5%. 2024 and 2025, the first two years of retirement, we have negative 27% and negative 10% declines to the portfolio value while simultaneously withdrawing income to support your lifestyle.

We see the trajectory of these two different paths. Everything else is identical after year two. The only thing that’s different is we suffer losses in the first couple of years of retirement and we see how dramatically that changes the trajectory of our portfolio value and ultimately your security in retirement.

Implementing Flexible Retirement Income Plans

Now, how do we mitigate sequence of returns risk? Honestly, there are multiple, dozens of different ways that we can attack this, probably more than that. I want to address it from a high-level perspective and pass the concept along to you. One, we need to be flexible. We need to be able to be nimble when markets change, portfolio values change. We need to be willing to adjust our spending levels in retirement. That’s number one.

Number two, be flexible with social security. Here’s a plan where maybe we’re planning on deferring social security until 70 or 67, but if we lose money the first two years of retirement, maybe one spouse should turn social security on. How does that impact the overall retirement income analysis? Maybe both spouses don’t defer until 67, maybe they defer to 62.

We used to be able to do a file and suspend strategy which is no longer available to us, but there are some social security strategies that we can implement. Most importantly, we need to identify how does turning social security on based on this change in portfolio value impact our account values, the longevity of our portfolio, and what does it do to our overall probability of success. The primary way that we mitigate sequence of returns risk is by diversifying different buckets of money over various time frames with specific purposes.

To keep this super simple, your example may be we have three, four, five different buckets here covering multiple time frames. Here to keep it simple, I’m just doing a low-risk bucket and a more risk bucket. Theoretically, with the low risk bucket, we should expect less potential growth. Because we’re going to withdraw income from this bucket, I just wrote years one through nine here. For you, it might be years 1 through 3 or years 1 through 6 or 1 through 12.

Some people will take growth from the more risk bucket and refill the low risk bucket whenever it starts to deplete. Others will try to live off the interest of this. You’re starting to look at the different ways we can mitigate sequence of returns risk, but the question has really become, this is why customizing your retirement plan is so important. What percent, meaning are we putting 20% of our money in this low-risk bucket, and for how many years are we planning to withdraw from that bucket? Are we putting 30% or 50%?

The Importance of Avoiding Emotional Investment Decisions

Everything we’ve talked about so far, your willingness to stay committed to an investment plan when markets are volatile, your need to balance risk versus reward. If we put too much into this bucket because we don’t have a willingness to stay committed, are we jeopardizing our long-term growth potential? We need to start thinking about all of these different aspects that we’re sharing with you to really make sure that you don’t overlook one critical element which could put you on a trajectory where things seem fine the first two, three, four, five years of retirement, but you’re on one of those trajectories to where, ultimately, it’s probably not going to end up well.

First we have to decide what percent are we going to put into the lower-risk bucket. How long is that money going to be there for us to withdraw from? It is okay to spend that down to zero as long as we have a strategy over here to grow it back.

The second thing we need to consider is which tools are we going to use in this low-risk bucket? We have options. We could use bonds. We could create a bond ladder. We could look at municipal bonds. We could look at corporate bonds. While interest rates are higher right now, we could look at CDs, possibly money market accounts. We could look at fixed indexed annuities, which ultimately, are like three products in one and it can also give you the option for a guaranteed lifetime income stream.

I would technically prefer some combination of money market, bonds, the fixed annuity because now we’re diversifying our low-risk assets. Everyone has different risks, and everyone has different concerns. CDs, for example, if we buy a one-year CD, what are we going to do in 12 months? Bonds, if interest rates come down, money inside that bond, if it’s a fund, gets reinvested at lower and lower rates, so your yield declines over time. If you’re buying individual bonds, you face significant market risk because the value can fluctuate, as well as inflation risk. Then with the fixed annuity, if you’re making a withdrawal, you also face inflation risk unless you’re withdrawing a larger and larger amount.

Downsides to all these different tools, that’s why typically we want to diversify these, and what we will see when we diversify those lower-risk tools, that not only can your risk score decrease, but sometimes your potential growth can increase.

Finally, we have how much growth. Now, I say finally because I only wrote three up here but there really is a lot more to look at when it comes to the overall customized retirement plan, but how much growth do we need? Going back to our seesaw example, we want to make sure that we have balance there, just like Bobby Flay. We want to make sure that we’re balancing out those ingredients so that the flavors taste tastes pretty good.

Now, the number one thing if we have all of this figured out, and let’s say, you’re on a great path on a great trajectory You’re enjoying retirement recession comes. The number one thing that you cannot do under any circumstance, unless you want to destroy your probability of success and put your family in a pretty precarious position, the number one thing we cannot do just go to cash. You cannot wait until the bottom of a market decline, panic because you’re going to feel like many of you will feel like, “This is all I can do to protect myself.” You cannot, once you have committed to a plan in an investment strategy, go to cash. You cannot sell everything.

The whole purpose of a retirement plan is to help connect you to give you visibility into how the impact of recessions and market pullbacks are impacting your long-term security. Now, if you drop from 99% to 82% in a recession and you sell and go to cash, guess what? One, you’re not going to be able to probably get back in anytime soon because the market rebounds far before the economy has good news and things are feeling comfortable. You’re probably stuck at 82%.

Whereas if you just went with the plan, allowed the market to pull back, adjusted some spending, withdrew from the low-risk accounts, we could buy time to allow that plan to come back or those investment accounts to come back, assuming markets do come back like they always do. If you don’t believe that you have no business being Invested in capital markets.

I want to close this video by simply saying the number one thing that you cannot do is go to cash. This is why we want to have that balance determined, focus on risk in terms of dollars, identify your willingness, everything we talked about in today’s video because sequence of returns risk is real and the emotional toll that it will take on you in those beginning years of retirement is serious.

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