Why ‘When’ Can Be More Important Than ‘How Much’ in Retirement

You’ve been good. You’ve scrimped and saved and saved some more and are nearing the much anticipated life transition known as retirement. With ample time, travel plans, and the feeling of freedom, who wouldn’t be excited? However, lurking in the background is one of the more disruptive and less known about risk factors which can significantly impact your retirement sustainability. This factor is known as the sequence of returns risk.

The sequence of returns risk is the risk that the order of investment returns as they relate to your portfolio can negatively affect your overall rate of return. In a nutshell, when you retire and rely on your investment portfolio to sustain your lifestyle by making withdrawals, negative returns in the beginning years of retirement can cause large losses. These losses are exaggerated by the fact that you are not making any more contributions  and are also withdrawing from the portfolio. Yikes! 

Lets’ explain with an example using 2 scenarios.

In both scenarios, we assume a starting portfolio value of $1 million. We also assume an annual withdrawal rate of 4% (though this ‘rule of thumb’ withdrawal rate has been challenged, we will use it for illustrative purposes). This $40,000 is withdrawn annually at the beginning of the year, and the return is applied at the end of the year.

Scenario 1

Year Return Ending Value After $40k Withdrawal
Year 1 -14% $825,600
Year 2 -4% $754,176
Year 3 21% $864,153
Year 4 12% $923,051
Year 5 8% $953,695


Scenario 2

Year Return Ending Value After $40k Withdrawal
Year 1 8% $1,036,800
Year 2 12% $1,116,416
Year 3 21% $1,302,463
Year 4 -4% $1,211,965
Year 5 -14% $1,007,890


As you can see, even though the portfolio had the same returns over the course of these 5 years, the order in which the returns occurred had a profound impact on the ending value after year 5. This ~$55,000 difference is about 5.5% of the beginning value!

Another way to think about this is assuming the same $1M portfolio and 4% withdrawal rate, you know you will need $40,000 annually to maintain your standard of living. If your portfolio drops to a value of $825,600 as it did after Year 1 in the first scenario, you will still need the $40,000 to live (just because the market drops doesn’t mean the cost of goods does as well!). So this 4% withdrawal rate now becomes an almost 5% withdrawal rate, which decreases the likelihood of sustainability in retirement. It can be difficult to recover in a scenario such as this.

So for those of you who know that you will need to withdraw from your portfolio to supplement living expenses, you might be asking what options do I have?

Unfortunately, nobody (including you) can perfectly time the market to be able to retire at the best time. It is purely up to luck. There are, however, certain strategies you can implement and have in place which can surely lessen the blow should you find yourself in this situation.

Cash/Liquid Reserves

During working years, it is recommended that you keep at least 3-6 months of living expenses in cash to insulate yourself from emergencies, which are of course a part of life. Once you begin the approach toward retirement, this cash buffer should be increased. We typically recommend 12 months AT A MINIMUM, with closer to 24 months being ideal. This doesn’t mean to keep the cash in your savings account earning next to nothing. You can look into short-term treasuries or CD’s. High Yield Savings accounts are also a great option, with rates significantly higher than traditional banks while still maintaining FDIC insurability.

Fixed Income Exposure

In a market downturn, it can be tempting to sell your equities as these typically experience the highest losses and volatility. But we want to avoid selling positions at their low point. Increasing your market exposure to fixed income can help protect against this temptation as they traditionally provide a hedge against stock exposure. We recommend high quality, lower duration bonds to high yield or junk bonds, as these can be highly correlated with the equity markets. 

Bond Ladder

A bond ladder is constructed by purchasing individual bonds which mature at yearly intervals and the principal plus interest earned is used to support your living expenses for that year. Since the bonds are held to maturity, they are not subject to price fluctuations and you are guaranteed your principal back (subject to issuing entities ability to pay back). For example, assume you know you will need $40,000 from your portfolio every year after social security. You could purchase $40,000 bonds with maturities ranging from 1-10 years, knowing that no matter what happens you will receive your interest plus the $40,000 every year. In positive markets, you would replenish the bond ladder by selling equities in a favorable market and if the market declines, you still have another 9 years in bonds coming due thus you could wait to extend the bond ladder until the market recovers.

Another way to accomplish this, using the above example of $40,000 living expenses, would be to maintain 10 years worth of living expenses in high quality bonds, or $400,000 in this case. While most bonds funds are subject to interest rate risk and price fluctuations, using high quality, low duration bond funds can limit these risks.

Work Part-Time/Consulting Work

One of the easiest ways to limit portfolio withdrawals is to earn some income during retirement. Many of today’s pre-retirees don’t see retirement as a hard stop from working, but more of a transition into being able to work in a role which provides more fulfillment and flexibility, without the ‘need’ to to work. Again using the above numbers, if you are able to earn $30,000 or so after tax, well this means you will only have to withdraw about $10,000 each year, which can drastically improve your ability to retire comfortably. I will talk more about this in another article.

Reduce Withdrawal Rate

Of course, you could always just reduce the amount you withdraw, but for most folks they don’t want to spend their retirement years being more frugal than their working years.

Use Your Home Equity

Using home equity could also be an option to avoid making portfolio withdrawals in a down market. Many lenders will allow you to take out a line of credit to be used solely for future use and not require you to maintain any sort of balance. Make sure if you utilize a HELOC to not go with a lender which requires a draw upfront, unless of course you plan to use the funds immediately.

Bottom line, be sure to have a plan in place to protect against factors outside of your control. This will help alleviate any financial worries you may have, particularly as you navigate your new life in retirement.

We hope this was helpful, for more information please feel free to contact us at 404-907-0070 or hello@fivepointsplanning.com.

Andrew Langdon is a fee-only financial planner based in Peachtree City, GA serving clients in the Greater Atlanta area.  FivePoints Financial Planning provides financial planning and investment management services to young families and pre-retirees who are looking to achieve financial freedom.  Services are offered on a project or ongoing basis.

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Andrew Langdon, and all rights are reserved. Read the full Disclaimer.