The Dramatic Impact of Sequencing of Returns on Safe Withdrawal Rates

In the last section you learned the critical role that data assumptions play in safe withdrawal rates by seeing how international data indicated a potentially lower return expectation than U.S. data.

In this section you will discover how safe withdrawal rates are actually dynamic, not static as commonly taught. You will learn how the sequencing of investment returns and inflation during your early retirement years will make or break your financial security.

The sequencing of returns problem is best illustrated in this example from William Bernstein. Assume you have a $1,000,000 portfolio with an average return of 10% where 15 years produced +30% gains and 15 years lost -10% to create the average 10% over the total 30 years. This would give you a compound return of 8.17% (compound is less than average due to volatility effects). More importantly, when you vary the returns sequences you get something truly shocking.

• If you are unlucky and start your retirement with 15 straight losing years, you can only withdraw 1.86%. Same annual returns, same average return, different sequence of returns—different result. This is absolutely critical to understand.

• Conversely, if you are lucky enough to start your retirement with 15 straight winning years, you can safely withdraw 24.86%.

These are astounding results!

Sequencing risk causes your safe withdrawal rates to vary from an average of 8.17% to as low as 1.86% (in this example) or as high as 24.86%. This variation is solely caused by the exact same returns occurring in a different order. Nothing else changed.

As shocking as these numbers are, it is really just common sense when you think about it. Imagine 15 years of no net investment gain (not hard to do with the stock market’s performance from 1998 - 2012) while still withdrawing 4% per year for spending. Even without inflation adjustments you would wipe out 60% of your account just in spending alone. When you add inflation and investment losses to the equation, the overall destruction to equity would be the retirement equivalent of death by strangulation.

By the way, this is not some strange, statistical mumbo-jumbo that has no bearing on your retirement. This is real-world stuff that is critical to your understanding. It can make-or-break your financial security. Real people retired in 2000 applying the conventional 4% wisdom and destroyed their nest eggs in the process because of this exact problem.

Sequencing of returns risk is a huge factor in explaining why actual safe withdrawal rates in U.S. historical data vary from the 3% range at the low end to over 10% at the high end (depending on assumptions and the date chosen to begin retirement).

Sequence of returns is determined by the date you retire, cannot be known in advance, and will be one of the most significant factors affecting your financial security in retirement.

It’s a big deal.

The truth is that safe withdrawal rates are all over the map depending on what date you retire and what happens to your investment returns in the early years of your retirement. Pfau (2010) concludes that retirement success is highly dependent upon early investment returns showing that wealth remaining after 10 years of retirement combined with cumulative inflation during those 10 years explains 80% of the variation in safe withdrawal rates. This is very similar to Bernstein above.

The importance of this issue cannot be overstated.

The problem is your next 10 years investment returns are unknowable; you don’t get to know the sequence of returns until after the fact. The future can’t be predicted with any accuracy and it certainly isn’t dependent on the last 100+ years of U.S. average historical data.

Lesson Learned:

Your real safe withdrawal rate for 30 years is highly dependent on the first 10 year’s sequence of returns and inflation rate. One size does not fit all. The 4% conventional wisdom is a static, least-common-denominator approximation, but actual safe withdrawal rates are highly variable. It is one reason why retirees in 1921, 1966, and 2010 face such dramatically different safe withdrawal rates.

What’s a near-retiree to do?

As it turns out, all is not lost. There are answers provided in the next section below, but they are not the same as conventional wisdom would lead you to believe.