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Sequence of Returns Presents Risk for Retirees | Baird Retirement Management

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May 31, 2016

May 31, 2016

5:07 AM America/Chicago

If you were guaranteed an average rate of return of 7% over the next 30 years would you take it? The simple answer for most retirees would be “Absolutely!” but the order in which those returns are achieved and the withdrawals taken from the portfolio can have an outsize effect on overall plan success rates. Baird defines sequencing risk as “The risk of lower or negative returns early in a period when withdrawals are made from an investment portfolio”. Specifically, let’s examine a scenario in which negative returns are achieved early in retirement.

Consider the following example in which a client retires with $1,000,000, gets an average arithmetic return of 7%, and wants to withdraw 4%, inflated at 3%, from their portfolio for 30 years. Various rules of thumb would approve of this spending plan; 4% is a fairly common withdrawal rate and we already know that the portfolio’s average return is higher than the planned withdrawals.

Rate of Return Year Portfolio Value Yearly Withdrawal

0

$ 1,000,000.00

21.53%

1

$ 1,175,311.62

$ 40,000.00

0.99%

2

$ 1,145,695.98

$ 41,200.00

13.20%

3

$ 1,254,449.30

$ 42,436.00

-5.08%

4

$ 1,147,002.59

$ 43,709.08

-8.66%

5

$ 1,002,613.95

$ 45,020.35

7.23%

6

$ 1,028,779.92

$ 46,370.96

12.84%

7

$ 1,113,080.06

$ 47,762.09

12.82%

8

$ 1,206,572.69

$ 49,194.95

-0.12%

9

$ 1,154,406.89

$ 50,670.80

21.35%

10

$ 1,348,731.76

$ 52,190.93

5.94%

11

$ 1,375,103.36

$ 53,756.66

9.05%

12

$ 1,444,128.98

$ 55,369.35

-2.76%

13

$ 1,347,264.13

$ 57,030.44

7.67%

14

$ 1,391,813.56

$ 58,741.35

10.51%

15

$ 1,477,630.31

$ 60,503.59

-10.99%

16

$ 1,252,933.49

$ 62,318.70

7.39%

17

$ 1,281,344.14

$ 64,188.26

12.84%

18

$ 1,379,731.74

$ 66,113.91

12.45%

19

$ 1,483,476.52

$ 68,097.32

6.32%

20

$ 1,507,055.77

$ 70,140.24

-11.31%

21

$ 1,264,336.44

$ 72,244.45

15.89%

22

$ 1,390,821.87

$ 74,411.78

36.29%

23

$ 1,818,976.28

$ 76,644.14

-4.40%

24

$ 1,659,990.87

$ 78,943.46

25.11%

25

$ 1,995,480.39

$ 81,311.76

-5.39%

26

$ 1,804,239.38

$ 83,751.12

5.33%

27

$ 1,814,169.95

$ 86,263.65

12.52%

28

$ 1,952,542.30

$ 88,851.56

19.11%

29

$ 2,234,242.50

$ 91,517.11

-17.68%

30

$ 1,745,060.21

$ 94,262.62

7.00%

$ 1,745,060.21

This 7% arithmetic return sequence worked well for our hypothetical retiree. The retiree grew their assets by $745,000 over 30 years and never ended a year with less money than they started with, an ideal situation for most any retiree.

Now consider the same sequence of returns with two changes. Assume that the year 30 return of -17.68% happened in retirement year 1 and the year 16 return of -10.99% happened in year 2. Other than these two changes the returns will occur in the exact same order as in example 1. Due to the transitive property, we know that this sequence of returns will also have an arithmetic return of 7.00%.

Rate of Return Year Portfolio Value Yearly Withdrawal

0

$ 1,000,000.00

-17.68%

1

$ 783,242.25

$ 40,000.00

-10.99%

2

$ 655,971.06

$ 41,200.00

21.53%

3

$ 754,773.25

$ 42,436.00

0.99%

4

$ 718,503.53

$ 43,709.08

13.20%

5

$ 768,298.95

$ 45,020.35

-5.08%

6

$ 682,891.30

$ 46,370.96

-8.66%

7

$ 575,968.28

$ 47,762.09

7.23%

8

$ 568,443.37

$ 49,194.95

12.84%

9

$ 590,742.40

$ 50,670.80

12.82%

10

$ 614,279.73

$ 52,190.93

-0.12%

11

$ 559,761.95

$ 53,756.66

21.35%

12

$ 623,925.98

$ 55,369.35

5.94%

13

$ 603,963.03

$ 57,030.44

9.05%

14

$ 599,857.56

$ 58,741.35

-2.76%

15

$ 522,807.68

$ 60,503.59

7.67%

16

$ 500,571.11

$ 62,318.70

10.51%

17

$ 489,007.52

$ 64,188.26

7.39%

18

$ 459,034.05

$ 66,113.91

12.84%

19

$ 449,868.44

$ 68,097.32

12.45%

20

$ 435,758.17

$ 70,140.24

6.32%

21

$ 391,043.00

$ 72,244.45

-11.31%

22

$ 272,397.28

$ 74,411.78

15.89%

23

$ 239,035.81

$ 76,644.14

36.29%

24

$ 246,850.35

$ 78,943.46

-4.40%

25

$ 154,676.23

$ 81,311.76

25.11%

26

$ 109,762.22

$ 83,751.12

-5.39%

27

$ 17,586.04

$ 86,263.65

5.33%

28

$ (70,327.91)

$ 88,851.56

12.52%

29

$ (170,653.55)

$ 91,517.11

19.11%

30

$ (297,535.62)

$ 94,262.62

7.00%

$ (297,535.62)

The sequence of investment returns has dramatically impacted the retirement of our hypothetical retiree. By achieving bad investment results early in retirement our retiree immediately fell below the initial $1,000,000 investment and never again had a portfolio worth that much even after returns improved in years 3, 4 and 5. Additionally, while the first scenario took our retiree through 30 years comfortably, the second case with bad returns early ran out of money early in year 28.

While this example shouldn’t be overstated, it does bring attention to the importance of timing risk to retirees. Scenario one experience the exact same returns as scenario two, but the fact that scenario two experienced poor returns early crippled the portfolio and impacted the retiree’s ability to spend comfortably throughout a full retirement.

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