Sequence of Returns and the 4% Rule

A couple of months ago we talked about the 4% Rule as it relates to a “safe” withdrawal rate in retirement.  It was discussed that the 4% Rule should be used as a starting point but not necessarily a hard-and-fast rule.  One factor that can lead to underestimating, or even overestimating how much you need for retirement and the safe amount to take out each year has to do with the sequence of returns.

Why does the sequence of returns matter?

When certain returns are achieved can matter as much as how much those returns actually are.  Let’s take a look at a study from Morningstar:

Assumptions:

 

  • A portfolio starting with $500,000
  • A portfolio mixture of 50% large-company stocks and 50% intermediate-term bonds
  • An initial rate of withdrawal of 5% (or $25,000) adjusted annually for inflation
  • Annual returns from the beginning of 1973 to August of 1994

 

Results:

 

  • If you take the actual returns in order starting in 1973 your $500,000 would be reduced to $0 by August of 1994
  • If you reverse the order of the returns (starting in August of 1994 and ending in 1973) your $500,000 would be worth about $1.75 million at the end of the hypothetical 21+ year period

The difference in the numbers can be explained by understanding the difference between arithmetic and geometric averages.  Put a simpler way, your retirement experience can vary greatly depending on the performance of your portfolio in the first few years in retirement. 

In future posts we will discuss how to mitigate some of the risks associated with taking money out during retirement.

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