Safeguarding Sustainable Withdrawal Rates: How Sequence of Returns Risk Can Make or Break Your Retirement

One of Savant’s Investment Maxims states: “Investment risk is more than large swings in value: Understand, measure, and evaluate all forms of risk.” To that end, investors and retirees face an often-overlooked portfolio risk that can shape their entire retirement experience.

Investors naturally seek strong returns during their working years and retirement. But it’s just as important to maintain a sustainable withdrawal rate once you retire. If poor returns hit early in retirement, your portfolio may shrink so much that future gains cannot restore it.

What Is Sequence of Returns Risk, and Why Does It Matter?

Understanding how the sequence of returns risk interacts with withdrawal rates requires both insight and testing. Researchers Dr. Wade Pfau and Michael Kitces have explained the mechanics and significance of this risk.

Kitces notes:

“Mathematically, the sequence of returns doesn’t matter when there are no cash flows in and out of a portfolio, even when there is extreme volatility. For instance, a $1,000,000 portfolio that experiences returns of -50% and +100% finishes with the same balance as a portfolio that has returns of +100% and -50%. In both cases, the portfolios finish with the same $1,000,000 that they started with…Once cash flow occurs, though, the results are different. In the logical extreme, imagine a retiree with $1,000,000 who needs to take a big $500,000 withdrawal at the end of the first year. With the ‘good’ sequence, the portfolio grows 100% from $1,000,000 to $2,000,000, easily funds the $500,000 withdrawal, and after the 50% drop in year two finishes with $750,000. By contrast, with the ‘bad’ sequence, the portfolio falls 50% to $500,000, and the $500,000 withdrawal completely depletes the portfolio down to $0, and the subsequent 100% return is now irrelevant because you can’t compound an account balance of zero!”

How Early Retirement Returns Shape Long-Term Outcomes

Modeling more typical examples over 30-year retirements, Pfau and Kitces show that the first decade of returns largely determines whether a portfolio can sustain healthy withdrawals throughout retirement.

Many planners discuss the 4% Rule, which addresses sequence of returns risk by setting an upper limit on withdrawals. However, another method can allow investors to withdraw more over their lifetimes while helping to protect them during the years they most want to enjoy their wealth.

The “Tent” Strategy: A Way to Potentially Reduce Retirement Risk

The core idea behind this strategy to manage sequence of returns risk involves creating a “tent” of bonds and alternative investments for up to the first decade of retirement. For example, a common approach is to help determine a multiple of annual withdrawal needs (often alongside Social Security modeling) and invest those funds without equity risk. Those funds are gradually spent, and the tent, or temporary increase in lower-volatility assets, normalizes.

Meanwhile, equity allocations have time to compound and weather potential market shocks without interruption from cash flow needs. This approach is designed to address a risk embedded in nearly all retirement plans while tailoring the strategy to individual goals.

Take Control of Your Retirement Income Strategy

Implementing a tent strategy is just one approach we may use to help clients pursue their objectives and address blind spots across all 10 Key Planning areas of their financial lives. Start a conversation with one of our advisors to help tailor your retirement plan to your unique needs.

This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. Please consult your investment professional regarding your unique situation.