I hope that most baby boomers who are close to retirement have developed a fundamental understanding of the “sequence of returns” risk as it applies to their retirement security. In a nutshell, the sequence of returns risk tells us that the annual returns on our retirement investments do not by themselves determine whether our retirement nest egg will support us until we die. Rather, we must also carefully consider when those returns occur. For example, a significant market downturn at the commencement of our retirement – say at age 65 – is much more dangerous than if the same downturn occurs ten years later, at age 75. Let’s think more about this for a minute.
Now let’s get more specific and analytic with a “Benjamin Button” type thought experiment put forth by Ron Surz at Think Advisor:
Assume that a retirement saver contributes $2,000 a year into a balanced portfolio (60/40 equities to bonds) from age 25 (1970) to age 64 (2008), accumulating a $800,00 retirement nest egg. Even though this nest egg experienced the awful 2008 market decline, this retirement saver still ends up with an impressive result because he had a generally positive sequence of returns.
Now assume a “Benjamin Button” scenario to study the same savings plan but accumulating in reverse, from 2008 to 1970. The same retirement saver ends up with $1.2 million, a 50% increase, even though he started saving with the disastrous market year of 2008, which shrunk his initial contribution.
Why the big difference? Again, it’s because the timing of the severe market decline applied to differently sized nest eggs.
This gives us clarity for the retirement accumulation phase. What about the retirement spending phase?
Assume that two hypothetical retirees invest more conservatively during retirement (40% in stocks and 60% in bonds and cash), and spend 5% annually of an initial nest egg of $500,000 with 4% annual spending increases for inflation. The retiree who retires in 1970 and enjoys the historical market returns through 2008 will have had 39 good years, with the initial $500,000 nest egg increasing by almost ten times, despite the 2008 market decline.
Conversely, again using the Benjamin Button scenario with the 2008 through 1970 sequence of returns, the retiree will have depleted his $500,000 nest egg in 1976, after only 31 years.
As you can see, changing the sequence of the same annual returns produces radically different results for the same starting nest egg. One of the results is quite scary for retirement security.
What do we do about this? Here are my takeaways:
1. Do not base the success of your retirement spending plan on assumed annual market returns (even reasonable ones) without also considering that the sequence of those returns will change the outcome. (This is where a Monte Carlo analysis of your plan can provide clarity.)
2. Consider separating your retirement nest egg to fund separate spending components (as I have) to eliminate risk for the “retirement needs” part of your spending plan. For the “needs” component, there is no market risk and therefore no sequence of returns risk.
3. Consider lowering your equity allocations at the beginning of your retirement plan and slowly increasing that allocation as the sequence of returns risk declines. For example, be wary of target date retirement funds that do not account for this.
For more on how this sequence of returns risk can affect your retirement, read this article from Think Advisor: What Makes Sequence of Returns Risk So Dangerous