New on FinoLib · Volume V: Personal Finance
My latest article is now live on FinoLib, the free finance library I write: Sequence of Returns Risk and Retirement Withdrawal Guardrails, from Volume V: Personal Finance. It is part 1 of a 2-part guide. Read the summary below for the substance of the topic, then continue to FinoLib for the complete treatment.
The idea in plain words
A retirement plan rarely fails because the average return was low. It fails because of bad returns early on, rising prices and a longer life than planned. Imagine driving across a desert: running low on fuel at the start of the trip hurts far more than running low near the end. The counters are spending rules that adjust to how your portfolio is doing, income that rises with inflation, planning for a life to age 95, and guaranteed income that covers your essential bills.
Key points
■The same fifteen returns in opposite order left two retirees $635,129 apart; the first decade’s real returns predict the outcome far better than the 30-year average.
■After a 20% loss with 4% withdrawn, the portfolio needs a 30.2% gain, not 25%, to get back.
■At 3% inflation a fixed income loses half its buying power in about 24 years.
■For a 65-year-old couple, the chance that at least one partner reaches 90 is about 51%; to 95, about 21%.
A closer look
Saving for retirement has one dominant risk: not saving enough. Spending in retirement has four, and they interact. Sequence-of-returns risk is the danger that bad markets arrive early, while you are already withdrawing. Inflation risk is the slow loss of what each dollar buys. Longevity risk is the chance of living longer than the plan assumed. The fourth is behavioral: holding spending fixed when the portfolio is signaling that it can’t sustain it. This section takes each in turn, with numbers, and then covers three tools for managing them — guardrails, buckets, and a guaranteed floor.
The mechanism behind sequence risk is simple. While you are saving, the order of returns does not change where you end up: a fixed sum multiplied by the same set of returns produces the same final value in any order. Once you are withdrawing, it does. Money taken out after a crash has to be sold at low prices, and those shares are not there for the recovery. Each year’s arithmetic is:
The consequence: the first five to ten years of retirement carry most of the risk. A plan that survives a bad first decade usually survives; one that assumes average returns from day one can fail with average returns over thirty years.
Inflation works more quietly. At 3% a year, prices roughly double in 24 years, and a retirement can last 30. The table shows what a fixed $40,000 a year is worth in today’s purchasing power, using today’s value = $40,000 ÷ (1 + inflation)^years — for example, $40,000 ÷ 1.03^20 = $40,000 ÷ 1.806 = $22,147.
A worked example
Worked Example — Same Returns, Opposite Order
Two retirees each start with $1,000,000 and withdraw $40,000 at the start of year one (a 4% initial rate, 10.2), raising the withdrawal 3% a year for inflation. Both experience exactly the same fifteen annual returns — an average of 6.0% — but Retiree A meets them in one order and Retiree B in the reverse order. Year one for A: ($1,000,000 − $40,000) × (1 − 0.18) = $787,200. Year one for B: ($1,000,000 − $40,000) × (1 + 0.09) = $1,046,400.
Under the hood
Under the Hood: Why Withdrawals Turn a Loss Into a Deeper Hole
A loss and a gain of the same percentage do not cancel: after a 20% fall, $1 becomes $0.80, and getting back to $1 takes $1 ÷ $0.80 − 1 = 25%. Withdrawals widen that gap because they shrink the base that has to recover. Withdraw 4% at the start of the year and then lose 20%: $1,000,000 becomes ($1,000,000 − $40,000) × 0.80 = $768,000, and returning to $1,000,000 takes $1,000,000 ÷ $768,000 − 1 = 30.2%, before the next year’s withdrawal. At 5% withdrawn the required gain is $1,000,000 ÷ $760,000 − 1 = 31.6%. The formula above shows the second half of the mechanism.
Research: It Is the Decade, Not the Crash
Planner and researcher Michael Kitces tested which returns best predict the highest safe withdrawal rate across historical U.S. retirement start dates (Kitces, 2014). The first year’s return predicted little. Real returns over the first ten years had a correlation of 0.79 with the safe withdrawal rate, peaking at 0.81 after nine years, while 30-year compounded nominal returns showed essentially no relationship.
What the full article covers
The full article includes worked examples, a look under the hood at the mechanics, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume V: Personal Finance
Read the full article on FinoLib
The complete article, Sequence of Returns Risk and Retirement Withdrawal Guardrails, with every worked example, diagram, quiz and source, is free to read in Volume V, Personal Finance on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance