Spending Less Early in Retirement: Sequence Risk and the Order of Returns
“Early retirement behavior matters most. The first 5-10 years of retirement have an outsized impact on long-term success. Spending less during these years provides a better likelihood of positive outcomes over the retirement horizon.”
Everyone knows that returns matter, but when you experience those positive and negative returns matters greatly. In other words, the sequence of returns matters.
Let’s say you retire just before a 10-year period of market decline that is followed by a 10-year rise in market value. You might consider the average market return to be fine, but this sequence of returns would actually be quite detrimental to your lifetime retirement income.
On the other hand, let’s say you retire just before a 10-year period of increases in stock market value that is followed by 10 years of falling returns. The average return is the same as the first situation, but because of the different sequence, you’ll be in a much more favorable position.
To understand the math that makes this true, take a look at this table that shows the impact of a fixed dollar drawdown under two different market conditions. In this example, our retiree starts with a nest egg of $1 million and his or her annual drawdown is $40,000:
On average, the 20-year returns are the same. But the first scenario (ten years of market decline followed by ten years of market increases) results in a significantly reduced nest egg after 20 years, while the second scenario results in a growing nest egg.
Since we can’t know what path the market will take, changing the drawdown strategy to a percentage of the portfolio instead of a constant dollar amount is one way to hedge against the risk of exhausting assets. The drawback of this alternate strategy is that annual income will differ from year-to-year based on returns. In this case, the first scenario is still much worse, but this alternative approach allows the nest egg to remain robust through the hard times.
For illustration, we look at the same market returns as the first example, but now we use a strategy that starts with a modest 3.5 percent drawdown and adjusts the percentage upward as the retiree ages.
By drawing down a lower amount of income from the retirement portfolio early in retirement, the retiree is at least partially hedged against the sequence risk experienced in the Down-then-Up Scenario.
On top of hedging the first scenario, the level of income is robust if the retiree experiences the favorable returns in the Up-then-Down Scenario.