Sequence of Returns Risk
It is among the most important things to know about retirement income planning and must be understood by anyone faced with the challenge of turning portfolio into income. The concept involves the risk of experiencing bad luck with your investments when you start to take withdrawals from your portfolio.
Consider the following hypothetical scenario, which reflects a portfolio of $100,000 sustaining $10,000 annual withdrawals. If the value of the portfolio drops substantially in the early years while being subjected to withdrawals, especially withdrawals increasing with inflation, that portfolio can be seriously diminished in value.
Year
What if the market ...
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Beginning Portfolio
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Withdrawal
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Ending Portfolio
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Year 1
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100,000
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10,000
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90,000
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Year 2 ... drops by 20%:
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72,000
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10,000
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62,000
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Year 3 ... stays flat:
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62,000
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10,000
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52,000
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Year 4 ... increases by 10%:
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57,200
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10,000
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47,200
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Year 5 ... stays flat again:
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47,200
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10,000
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37,200
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You can see how in short order your portfolio can face extinction. The $10,000 withdrawal is fixed (and even will need to increase with inflation), whereas the pool of resources is shrinking. A 10% increase in a $100,000 portfolio ($10,000) is enough to sustain withdrawals of $10,000, but a 10% increase in a $37,000 portfolio ($3,700) is not.
I have seen a study reflecting the ten years beginning around the year 2000, just prior to the popping of the Dot Com bubble, encompassing the Great Recession of 2008, and ending around 2010. A portfolio of all stocks would have been totally exhausted by the $50K withdrawals, and ended with $0.
The $10,000 withdrawal drops when you choose to retire (or are forced to retire by your employment situation or poor health), the amount of the withdrawal is a higher percentage of the pool than it was at the start. Thus, in the example above, $10,000 is 10% of the $100,000 at the beginning, but it is more than 26% of the number at the end. And you need that $10,000 to pay your expenses, so reducing that number is not an option.
What to do to guard against this risk
- The portfolio mix (stocks/bonds) during your ac-cumulation years must differ from the portfolio mix during your de-cumulation years. If you are going to take withdrawals, your portfolio cannot withstand a 20% hit. You need to lower its risk as measured by its standard deviation.
- For this reason, among others, the adviser you've used during your accumulation years may not be the best adviser during your retirement. Consider hiring someone, whose focus is retirement income planning.
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