Today I want to share a risk that many people aren’t aware of as they approach retirement:sequence of returns risk. When you retire, there’s no way to predict what the market is going to look like. You’ve planned to withdraw from your retirement portfolio to fund your retirement. But what happens when you have to make withdrawals in a down market? How will it impact your portfolio? How will it impact your retirement? In this episode of UpThinking Finance, I’ll talk about the different variables at play, what sequence of returns risk is, and how we can preserve your portfolio from varying returns.
Let’s say someone’s goal is to withdraw $10,000 a month to cover their expenses in retirement. How do we help them work toward that goal? First, we add up fixed income sources such as social security, pensions, or rental income. Let’s say these total $5,000 a month. What’s next? There are two ways to approach supplementing that additional income.
The first is through dividends. You can build a portfolio around investments that generate a monthly or quarterly distribution check, such as a municipal bond portfolio. If we need another $5,000 a month, the portfolio needs to generate $60,000 a year in dividend income.
The second strategy is a capital spend-down plan. We systematically sell shares or principal from the portfolio and it eventually depletes to zero. This is the route that most people take. Very few clients can rely on fixed income and dividends alone. If you draw 4% of your portfolio, you should be able to average a 4% gain and offset your spending. But this comes with risk.
What kind of returns is the market providing as we’re liquidating a portfolio? We might have a general idea of what the market will do, but we can’t predict it, right? The variance compression principle states that the longer you go into an investment cycle the less variable the returns will be year to year. The reality is that it’s unpredictable. If we don’t plan for sequence of returns risk, it will derail your retirement.
In this episode, I’m looking at a series of 20-year returns from 1989 to 2008. We’ve also inverted the order of the returns to start in 2008. Why’d we invert it? The market was up 31.69% in 1989. But when you invert the returns, we see that 2008 was down 37%. This will show us how a retirement portfolio fares starting with a bad year or a good year.
Let’s say we start with $1 million, are invested in the S&P 500, and draw out $50,000 a year (including the 3% annual inflation adjustment). After 1989, the portfolio’s ending balance was $1,266,900. But when we look at the returns starting in 2008, the portfolio was down to $580,000. That account lost half its value between the market and the drawdown in the first year.
Making that up would require the portfolio to have a 100% gain. That’s not only near impossible but it’s incredibly risky to attempt achieving. Eventually, after 18 years, the inverted portfolio ran out of money. The portfolio that started up 31.69% in 1989 ended its twenty-year run at $3,073,031.00.
How do we ensure that we’re not selling assets into a down market? By using income segmentation also referred to as the bucket strategy. In this example, the buckets/segments start in three-year...
