Why "Sequence Of Returns" Matters

As you develop your financial plan for retirement you will give a good deal of thought to the known details of your finances (e.g. monthly expenses, income, etc.) and what you expect/would like to happen in the future. You will also need to decide what rate of return you should use for your savings/investments. Since you can't predict the future, you may end up relying on your historical results to arrive at a reasonable expectation. That makes sense, but how you choose to enter that information can have a serious effect on your results. If you expect a 5% return overall, entering 5% for every year may not be the best idea. My blog post from 11/1/19 ("Why Using An Average Investment Return Rate May Be Risky") explains the possible pitfalls of doing this. The end result was that using a variety of higher and lower return rates may prove to be more realistic than smoothing the results out to mimic an average historical return for every year. For example, $1M earning 7.16% for 20 years (the S&P historical average for the past 20 years) results in $3.9M. Using the actual S&P results for every year results in $2.8M.

There is another consideration that comes into play. It's not just varying the yearly return rate that's important, it's also the timing of those returns. There is a term called, "sequence of return", that should play a role in your planning process. The order in which you receive your returns is just as critical as the returns themselves.
This only becomes a factor in retirement, when you start taking disbursements. Before retirement, your balance is only affected by returns, so the order in which they arrive doesn't matter. The end result is what it is. However, once you start taking distributions, the order of returns matters, and it can matter a lot. Let's assume you start with $1M, take a $50,000 disbursement each year, and earn the following returns:

Year 1    25%
Year 2      8%
Year 3    10%
Year 4   -15%

At the end of 4 years your balance would be $1,072,510.

Now use the same assumptions, but reverse the sequence of returns:

Year 1    -15%
Year 2     10%
Year 3       8%
Year 4     25%

At the end of 4 years your balance would be $1,008,000.

The overall rate of return is the same in both examples (7%), but the difference in the ending balances is $64,510 in only 4 years! Over 20 years that could potentially amount to more than $320,000. The sequence of returns matters.

While you never want to lose money, experiencing a market downturn, particularly at the beginning of retirement, and having to take disbursements at the same time, is a double whammy that may be hard to recover from. While you have no control over your returns (other than diversifying your investments and limiting your risk to what you feel comfortable with), there are a couple of steps you can take to help mitigate the risk of "bad luck".

First, stress test your financial plan by entering a variety of return rates over the years, even if they are in close proximity to each other, rather than the same rate for all years. Second, enter low return rates, and even some negative rates, right at the beginning of retirement and then in the middle of retirement. You are trying to find out how your savings would hold up over time with less than stellar results. Don't be afraid to create "the perfect storm". You can't predict the future, but you can be prepared for it. Third, keep several years of expenses in cash or very liquid accounts. Remember, the biggest risk of not achieving the return rates you expect happens when you have to take money out of those accounts. Low returns may hinder your progress, but low returns and lowering your balance at the same time will hurt far worse. Being able to minimize the impact of low/negative returns, particularly early in retirement, can greatly improve the odds of not outliving your savings.

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