When you retire, you start a new chapter, but the journey to get there is tough. Once you’ve reached your goal, the race is still far from over. As difficult as it may feel, the most dangerous part of your journey will be during the money spending phase. While most investors focus on the total amount in their “nest egg” portfolio, they completely overlook the Sequence of Returns Risk. The timing of your withdrawals relative to market downturns will mathematically determine potential permanent destruction to your lifestyle. The first few years of your retirement are the most critical because if you have to draw down from your portfolio during a market decline, your portfolio could be depleting at a rate that is impossible to recover from. This “important” step is all about shaping a good withdrawal strategy.
Understanding the Math Behind Early Losses
To understand why the order of returns is more critical than the average return is because of how we have to look at the math of compounding backward. While you are working, a decline in the market value of your investments is actually a positive thing because you are still adding more money to the investment account. Once you start withdrawing money from the account for expenses, the opposite is true. If your value of your investments drops 20% in the first year, and you are withdrawing 4% from the investment account to cover mortgage and grocery expenses, you aren’t just losing money because the market has gone down, you are losing shares, which are the most valuable at that time. This is a reverse compounding effect, and even though the market is predicted to grow in the 5th year, you likely will not have any shares remaining that will be able to grow in value. In the first bull market after a bear market, a number of retirees demonstrates that average market activity permits them to spend from an investment account for a stipulated number of years. In contrast, a number of retirees demonstrates a bear market that provides them with a strong probability that they will outlive their money, even after the market activity averages are considered.
The Impact of Market Inversion and Rate of Return on Number of Years a Portfolio Will Last
The following table shows how different investment portfolios, that have the same average annual return, can have completely different results because of the timing of the bad years.
| Retirement Scenario | Average Annual Return | Initial Portfolio Value | Result After 20 Years |
| Early Bull Market | 7% | $1,000,000 | Portfolio Grows to $1.4M |
| Early Bear Market | 7% | $1,000,000 | Portfolio Depleted to $250k |
| Consistent Returns | 7% | $1,000,000 | Portfolio Remains Steady |
Using the Three-Bucket Strategy to Create More Stability
To prevent being too exposed to any risk, experienced financial planners recommend distancing themselves from a single account and instead opting for what is known as a “Bucket Strategy.” This “Bucket Strategy” involves splitting your investments from the account based on the overall time period for which they will be needed. The first account will have 2 to 3 years worth of your living expenses in a cash management account, savings account, or in a short term CD. This is a safety net. If the stock market goes down the second year of your retirement, to not touch the investments in stocks, and draw from this cash account instead, allowing your stocks to recover. The second account consists of income generating assets, which can be in the form of bonds or dividend stocks, for the period of 5 to 10 years. The third account is for holding a portfolio of long term growth stocks. By separating your cash from the market, you are giving yourself the luxury of ignoring temporary downturns in the market that would otherwise reduce your income permanently.
The Importance of Flexibility and Dynamic Spending
A trustworthy retirement plan involves stepping away from rigid rules about withdrawals and spending dynamically. The 4% rule states that you can withdraw 4% of your original balance (adjusted for inflation) every year. Many people find this rule to be too inflexible for today’s markets. As such, a more sophisticated approach involves “guardrails.” If your portfolio does really well, you can reward yourself with a trip or a home renovation. But if your portfolio falls below a particular level because of an economic downturn (aka a market correction), you need to be ready to cut back on discretionary spending. This kind of flexibility really works to “relieve pressure” on your portfolio. The idea is that by reducing your spending during “skinny” years, you will protect your underlying investment and your income stream will be strong enough to carry you through your 80’s and 90’s.
Constructing a Resilient Legacy With Professional Oversight
A successful retirement isn’t simply achieving a certain number; rather it is about achieving a particular number and being able to sustain that standard of living, irrespective of what happens on Wall Street. Wall Street is out of our control, and successfully constructing and defending a Wall Street resistant sequence of returns begins with tax efficient withdrawal sequencing and includes a diverse assortment of asset classes that are not perfectly correlated plus, and this is a big plus, the emotional control to avoid the urge to act on a plan when the headlines become bothersome. As we head into a world exhibiting longer lifespans and shorter economic cycles, the “protecting the distribution phase” is the of all steps to take “crucial” to not just surviving a retirement, but having the pleasure of a comfortable retirement. Talking with a fiduciary planner about the stress your retirement plan can take from various market stressors can clarify how to maintain your permanent wealth as long as the time spent more than the value of your vacations.
FAQs
Q1 What is the most dangerous time for my retirement savings?
Perhaps the most dangerous phase is the “Retirement Red Zone”. This term is understood best as the 5 years preceding retirement and the 5 years after. This consists of the most dangerous and most likely to occur sequencing risks in the market during this time.
Q2 Is it possible to avoid sequencing risks by having a diverse assortment of stocks?
That is true, but not all that true. In a serious economic recession, most publications of every caliber will likely increase, and during that time, stocks typically drop together, meaning the sequencing risk is still there. In order to cage the risk, other assets that are uncorrelated, like cash or those short-term bonds, are needed.
Q3 Should I stop taking money out if the market crashes?
You don’t need to stop completely, but it is often a good idea to lower your withdrawal rate, or use a cash reserve during downturns, as it greatly improves the chances of your money lasting throughout your lifetime.
