Ahh, my favorite time of the year is here. College football is about to kick off, hoodie weather is quickly approaching, the smell of ribs on the grill is nearly wafting through my window, and the sounds of the Volunteers running through the power T on a Saturday afternoon will soon fill my ears. What more could one person ask for? Relaxing into these fall rituals is something I wish for everyone, but those with unsettled financial plans may not be able to soak in simple pleasures like this. Over the next few months, I’m going to be writing on some of the lesser known, more confusing financial topics that we’ve been covering in our client meetings recently. My hope is that this newfound information can help you better understand your financial choices and give you more confidence to enjoy the fun of the fall. Let’s dive into today’s topic: sequence of returns.
Sequence of returns means how your portfolio is performing while you are pulling funds from your retirement accounts. When the market is going up and you’re making money, pulling out funds to live off is not a big deal; however, when the market is going down and you are pulling funds out to live off, there can be a major impact on your long-term retirement planning.
For better clarity, let’s look at a fictitious example*—we’ll call the two families the Mallards and the Smiths. Say both retire with a $1 million dollar portfolio and need to withdraw $50,000 per year to cover their living expenses (they never need to increase their withdrawals). They are invested in the same portfolio of 60% S&P 500 and 40% 10-year treasury bonds, but the Mallards retired in 2000 and the Smiths retired in 2010. After 10 years of retirement, the Mallards have ~$970,000 in their retirement funds and the Smiths have ~$2.33 million. This difference can be attributed to sequence of returns.
The first 10 years of the Mallards retirement was the lost decade of the 2000s. The S&P 500 return was virtually flat during this period but, luckily, their portfolio included both stocks and bonds, which helped moderate volatility during that period. The Mallards were thankful for their bond portfolio and were able to continue funding withdrawals during that period while preserving a substantial portion of their portfolio. Compare that to the first 10 years of the Smiths retirement, which was a bull market where the S&P 500 returned roughly 318% over those 10 years (source); the Smiths were able to draw their $50,000 and continue to make money during this strong market period.
Withdrawing money during down markets is like running in wet concrete if you don’t have your assets allocated appropriately. If the Mallards would’ve been in an all-stock portfolio, instead of a mix of stocks and bonds like used in the earlier example, their balance after 10 years would have been ~$343,000 (compared to ~$970,000 from the previous example). That’s a massive difference that could lead them to run out of money later in life.
When it comes to downturns, a 57% loss requires a 132% gain to get back to even. A 35% loss only requires a 54% gain to recover. If you’re drawing funds out while your account is down 57%, it’s going to take more than a 132% gain to recover. I cannot emphasize enough the importance of downside protection, asset allocation, and a withdrawal strategy that safeguards you during down markets. *This example is hypothetical and is provided for illustrative purposes only. It does not represent the performance of any actual investor or account. Results are based on assumptions that may not reflect actual market conditions, investment costs, taxes, inflation, or individual circumstances.
The years surrounding retirement can have a significant impact on long-term portfolio sustainability, making portfolio construction particularly important. Many advisors incorporate retirement income planning and portfolio reviews several years prior to a client's anticipated retirement date. Preparing early and understanding how your current strategy helps you navigate down markets versus just going blindly into retirement because the markets have been “good” lately is essential—and a priority for us at Smith Complete Wealth.
Having an advisor that looks out for your complete financial health including asset allocation, market volatility, and the sequence of returns is critical for your retirement planning. You should have a team surrounding you that understands the appropriate allocation for your goals. Investors may benefit from discussing withdrawal planning, risk management, and market volatility with a financial professional.
--
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
All investing involves risk, including possible loss of principal. Diversification and asset allocation do not guarantee a profit or protect against loss.
Stock investing includes risks, including fluctuating prices and loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.