The stock market’s average return can be a misleading statistic for investors like retirees that are steadily withdrawing from their portfolios. The hidden “Sequence of Return Risk” can be even more consequential. Retirees especially need to consider this risk as they plan their portfolio withdrawal strategy and asset allocation.
When there are no withdrawals from a portfolio the order of returns does not affect its future value. The only thing that matters is the compound annualized return. For example, if the compound annualized return of a $1 million portfolio is 10%, its value after a decade will be $2,593,740, no matter if the first 5-year’s returns were 0% a year and the next 5-year’s returns were 21% a year or vice versa. However, if there are withdrawals, the situation is different.
Let’s look at some examples.
Paul retires with a $1 million and decides to withdraw $50,000 at the start of each year. In the first scenario above he would have $1,486,157. In the second scenario he would have $1,884,593. A difference of over $400,000 due only to the sequence of returns, since both scenarios had the same compound annualized return.
This doesn’t look bad, even under the first scenario. However, what if the market’s compound annualized return was only 5%, over the decade? In the first scenario Paul’s portfolio would have shrunk to $883,448 after a decade, while in the second scenario it would have grown to $1,046,720. Since retirements can last for several decades, in the new first scenario Paul would have a higher likelihood of running into trouble later in retirement.
As we’ve seen this year, it's not unlikely that sometime during a long retirement there will be several severe market downturns, even a crash like 2007-09 when the market fell over 50%. Let’s look at two scenarios for investors’ results depending on when in a decade it happens. We’ll assume a crash of 50% one year in the decade, a 7% return for each of the other 9 years and the same $50,000 annual withdrawal at the beginning of each year.
If the crash occurred in Year 1, Paul would have $358,548 at the end of the decade. If the crash occurred in Year 10, he would have $598,818. In either case Paul’s portfolio would be seriously impaired but in the latter case he would have $240,270 more.
What can an investor do to mitigate these real risks?
First, he must understand that the timing and amount of the market’s returns are not under his control. What he can control is his asset allocation between bonds, stocks and cash, and his annual withdrawal-rate.
The more cash and shorter-term investment-grade bonds in his portfolio, especially early in retirement, the less their portfolio will be exposed to the sequence of return risk. The smaller the annual withdrawal-rate, the more likely the portfolio is to survive these risks. Finally, using a dynamic rather than a fixed withdrawal-rate will also help. For example, reducing the withdrawal-rate when the portfolio’s value falls, say 5%.
All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at firstname.lastname@example.org. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.