How to Eliminate Sequence of Returns RiskOne of the biggest problems with retirement is whether your portfolio will last. In the FIRE community, we have a good starting point. If you save up 25x your annual expenses, you’ll probably be okay financially. This is based on the 4% safe withdrawal rate. Basically, you can withdraw 4% plus inflation (around 2%) every year and your portfolio should survive for 30+ years. However, sequence of returns risk is still a big issue. A few bad years can screw up your retirement portfolio. Today, we’ll quickly go over sequence of returns risk and see how we can eliminate it.

Sequence of Returns Risk

Sequence of returns risk is the risk of retiring at the wrong time. If the stock market crashes right after you retire, your portfolio will deplete much quicker than normal. You’ll have to sell your investment at a lower price to fund your living expenses.

Let’s look at 2 examples. Here are the assumptions.

  • Retired with $1,000,000
  • Withdraw $40,000 per year with 2% increase every year
  • Invest 100% in VFINX (S&P 500 index fund)
  • 10 years period

Case 1 – Lucky retirement

This is the best-case scenario. If you retired at the right time, you can spend $40,000 + inflation every year and your portfolio will still increase nearly three folds. This chart is pretty amazing. Guess what year this lucky person retired. See the answer below the chart.

sequence of returns risk

Our lucky retiree stops working 10 years ago, January  2010. The last 10 years have been a very good decade for investors.

Case 2 – Unlucky retirement

This is the unlucky scenario. This person retired at the wrong time and the retirement portfolio depleted much quicker than in case 1. After 10 years, the portfolio is worth about half of where it started. Guess what year this person retired in.

sequence of returns risk

Our unlucky retiree stopped working on January 2000. The dot-com bubble busted and the portfolio was hit again with the global financial meltdown. This unlucky retirement portfolio was hit with a double whammy. Will this retirement portfolio last 20 to 30 more years? I’d be completely stressed out if this was my portfolio.

Eliminate Sequence of Returns Risk

Is there a way to eliminate sequence of returns risk? Here is my idea – retire early.

What? How?

Simple, if you retired early, you can go back to work when the stock market tanks and stop withdrawing for a while. Basically, you will have the best secret weapon – time.

Let’s plot the difference between going back to work occasionally and stopping work completely.

*Several readers mentioned that going back to work in the same field isn’t realistic. I mostly agree. After 8 years, there is no way I can go back into engineering. However, there are plenty of other ways to earn. I can pick up more side gigs like driving for Uber and pet sitting. Or pick up a seasonal job with Amazon.

eliminate sequence of returns risk

Here, I extended the timeline out to 20 years. The red line represents someone who retired and never earns any money after that. The blue line shows someone who got stressed out about the retirement portfolio and went back to work during the bad years. This person worked for about 2 years during the dot-com bust and a year during the global financial crisis.

Early retirement is the answer to sequence of returns risk because going back to work is much easier if you retire early. Let’s say our blue line gal retired at 40. It’s not that hard to go back to work for a while when she’s 41 and 49. Now, she’s 60 and can enjoy retirement without any more stress. This blue portfolio should last 30 more years.

On the other hand, if you retired at a regular age – our red line guy at 65. It’d be much more difficult to go back to work at 66 and 74. In 2020, he’s 85 and his retirement portfolio doesn’t look great. Well, he probably won’t live 30 more years so it might be enough. That’s one advantage to retiring at a normal age, the retirement portfolio won’t need to last that long.

Anyway, we can see that the portfolio recovers much better if you can stop withdrawing during the bad years. The blue portfolio is worth twice as much as the red portfolio after 20 years.

Other ways to mitigate Sequence of Returns Risk

My answer for SRR is early retirement. However, there are other ways to mitigate the problem. Experts also recommend these.

  • Withdraw less than 4%. I’m not a big fan of this one. If you lower the withdrawal rate to 3% in our example above, the retirees would have to accumulate $333,333 more. I think that’s probably more than 3 years of working.
  • Dynamic withdrawal – withdraw less during bad years. But how can retirees withdraw less? They’d have to cut expenses or earn income somehow. This is why I say early retirement is the answer. It’s not hard to make money when you’re young and healthy.
  • Dependable cash flow – pension, annuity, Social Security Benefits, reverse mortgage, etc… If you can get income from other dependable sources, then sequence of returns risk won’t affect your portfolio as much.
  • Bucket strategy – build a big bond/cash buffer. This one is pretty popular in the FIRE community, but I’m a bit confused. Basically, you keep 3-5 times your annual living expenses in bond/cash. That’s a big allocation. It will help during bad years, but it’ll be a big drag most of the time because the interest rate is so low. Also, when do you sell stocks to replenish the bond/cash allocation? You’ll have to time the market just right. If you have a good post on this strategy, please add a link in the comment section.

Early Retirement is the answer

For me, early retirement is the best way to eliminate sequence of returns risk. SRR is a big issue during the first decade of retirement. Once you’re out of the danger zone, your portfolio should be fine. Someone who retired in 2010 should be in a great position today if they minimize their lifestyle inflation. Their retirement portfolio grew significantly and it should be able to weather an economic downturn.

So, retire by 40 and be lucky. If you’re unlucky, then work a bit during the downturns. That’s way better than working until 65, right? The stock market goes up more than down so your chance to be lucky is pretty good. Historically, the US stock market is positive 75% of the time. We’ll most likely be fine and won’t have to go back to work. I like that kind of odd.

Alright, what do you think of my answer to sequence of returns risk? Am I too optimistic because the stock market did so well recently? How do you mitigate SRR?

Planning for retirement? You need a good retirement calculator. Personal Capital has a great one. It will take all your accounts into the calculation and help you figure out if you’ll have a successful retirement. Sign up for a free account at Personal Capital if you don’t have one yet.

Image credit – Lubo Minar

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