Jeff Walters, CFP^®

In our work with pre-retirees, we've heard one question more than any other lately: “What if the market goes down right after I retire?” This is a valid concern and touches on one of the most important concepts of retirement planning. This concept is called “sequence of return risk.” Essentially what this means is that the order and timing of returns experienced as an investor is just as important as the average annual returns realized over the investor’s retirement timeframe. Studies have shown that a retiree who experiences high, positive returns in the first decade of retirement will have a much higher chance of success than a person who experiences low returns during the first decade of retirement. This is true even if the average return is the same for each person after 30 years of retirement!  (Note that this is the opposite for a consistent saver in the accumulation phase of retirement who would prefer the higher returns to come later—after they have accumulated more savings.)

For the investor planning for retirement, here are some steps you can take to understand and mitigate your sequence of return risk:

A starting point

The first step is to prepare a projection of your expected expenses in retirement. We suggest separating these into two categories—essential (healthcare, utilities, food, etc.), and variable (travel, entertainment, etc.). Next, take into account any expected retirement income such as social security, a pension or part-time work. Assuming there is a gap between your income and expenses, it will be important to determine a reasonable annual amount to withdraw from your portfolio while ensuring your nest egg will last your lifetime—even if a bear market occurs early on during your retirement. This is an important decision in the retirement planning process. It will not only help you determine if you’re ready to retire, but also show you what a sustainable lifestyle looks like.

What is sustainable?

So how do you know what is sustainable? One of the first studies to look at mitigating the sequence of return risk was conducted by William Bengen in 1994 and followed up by another study named the Trinity study in 1998. These studies examined historical 30-year retirement periods to determine the minimum safe initial withdrawal rate from retirement portfolios. They determined that assuming a 50 percent stock/50 percent bond allocation and an initial withdrawal rate of 4 percent, you could increase the annual withdrawal amount by the rate of inflation each year with very low chance you would run out of money during a 30-year retirement. This concept is popularly known as the “4 percent rule.” Recently, given the current starting point of lower than average interest rates and higher than average stock market valuations, some researchers have questioned whether a 4 percent withdrawal rate is realistic in the current economic environment. As financial planners, we are watching these developments closely, but the balance of the research, from a quantitative perspective, still supports a 4 percent initial withdrawal rate even in the current environment. (For an in-depth look on how the 4 percent rule has held up since the financial crisis, see this article.)

Course corrections

While the 4 percent rule can be a good starting point for analysis, our client’s unique financial situation determines their most prudent withdrawal rate. When taking into consideration asset allocation, risk tolerance, estate goals and potential blind spots in their budget, the starting withdrawal rate can be lower. But no matter where you start, you will likely need to make adjustments along the way. If you find that your investments are significantly outpacing projections several years into retirement, (you are experiencing a “good” sequence of returns), then you could increase your retirement spending appropriately. Conversely, if you are experiencing a bad sequence of returns, it may be important to reduce spending. Typically, these can be gradual changes such as skipping an inflation adjustment during a year when the portfolio is down. Careful and thoughtful planning upfront to identify essential vs. variable expenses, starting with a reasonable withdrawal rate and having flexibility with variable spending, will make a large impact on your chances of success. With our retirement planning clients, we help track their portfolio withdrawals and suggest adjustments to maximize opportunities and support long-term success.

Probabilities

One of the tools we use with our clients to monitor their plans and decide when and what adjustments need to take place is called a Monte Carlo simulation. This measurement tool takes into account sequence of return risk to determine a “probability of success” based on historical return patterns. For example, if after entering your actual retirement spending numbers the simulation returns an 85 percent probability of success, this means that historically, adjustments to the plan would have been needed 15 percent of the time. We can then proceed to consider what those adjustments might be such as forgoing inflation adjustments during years when the market is down. By returning to this analysis each year you can make wise choices as a retiree when it comes to future spending decisions.

Planning and flexibility

Careful planning combined with flexibility in implementation is the hallmark of a successful retirement plan. By starting with conservative assumptions and building in the ability to make small changes as your retirement timeline unfolds, you can greatly increase your chances of a successful retirement regardless of short-term market conditions.