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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.”

From Savings to Income (AIER 2014)

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:

20140728_Table1

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.

20140728_Table2

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.

You can read more on Retirement Drawdown Strategies in our latest Research Study, From Savings to Income, here.

3 Comments Post a comment
  1. Gilbert W. Chapman #

    Good Afternoon, Mr. Delorme ~

    An excellent essay, but let me offer an entirely different approach.

    Let’s say you dollar cost averaged into mutual funds, at a rate of $100 per month, for your entire 40 year working career. Considering the impact of volatility, you would probably end up with $500,000, or even (if you’re lucky) close to $1,000,000.

    Rather than apply your ‘system’, why not liquidate the portfolio on a “Share” basis?

    Example ~

    Upon retirement you own 50,000 shares of an S&P 500 Index Fund, with a value of $10.00 each, and a total value of $500.000.

    You decide to liquidate “X” shares each year, say 2,000 in year one for an income of $20,000. And, for the remainder of your life, you continue to 2,000 shares, and you allow the additional shares purchase with capital gains and dividends to accrue.

    Yes . . . Your income will fluctuate significantly, with years of cash flow being greater than the original $20,000 in good years (Bull Market), and considerable less than $20,000 in bad years (Bear Markets). However, what no one seems to consider is that some expenses can be deferred until the good times roll again. I.e. a new roof on your residence might be put off for a year or two,a new car purchase could be deferred, or a trip to Europe could be scheduled for a future year.

    Granted . . . There are some potential pitfalls in my system . . . You could die before that trip to Europe was properly funded . . . But your surviving spouse would be able to continue to live well.

    I’ll stop here with my thoughts . . . Something tells me you probably already grasp my concept.

    Thank you for ‘listening’ . . .

    Like

    July 28, 2014
    • Luke Delorme, Research Fellow #

      I like the idea. It’s a clever approach.

      Something I didn’t mention in this piece is an important point that you raise: The volatility of returns can help during the accumulation of assets when you contribute at regular intervals (dollar cost averaging).

      Like

      July 28, 2014
    • Luke Delorme, Research Fellow #

      Mr. Chapman,

      I was thinking more about this strategy. My concern with it is that it still suffers from two pitfalls common to many drawdown strategies:

      1. Longevity Risk – In order to optimally pre-select the number of shares to cash in each year, you need to know exactly how long you’ll live. You still run the risk of exhausting assets if you choose a window that is too short, or potentially under-spending if you choose a window that is too long.

      2. Income Variability – The retiree is still subject to income variability under this strategy.

      I really like the strategy anyway, and I’d like to work on modeling it in future research. Thanks again for adding valuable insight.

      Like

      July 30, 2014

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