Unfortunately in the real world, market returns are not a constant 6%, rather they are not constant at all and can fluctuate significantly year to year. Let’s assume you have a portfolio that has an average annual return of 6%, with repeating series of returns - depending on when you retire you can get (+6, -13, +25) or (-13, +6, +25) or (+25, +6, -13).
Pre-Retirement The Sequence Of Returns is Irrelevant
During the accumulation phase the sequence of returns does not matter. When there are no withdrawals, a $1,000,000 initial investment after a 3 year cycle will always ends up being worth about $1,152,750 no matter what order the returns come.
When you start retirement income the sequence of returns makes a significant difference in portfolio longevity. Assume you retire today at age 65 and you have a $1,000,000 portfolio and need $50,000 annually and want it adjusted for the historical inflation rate of 3.6%. The best sequence with the positive returns coming first, (+25, +6, -13), means your annual income will last until age 94. The worst sequence with the negative and smaller positive returns coming first, (-13, +6, +25), results in your portfolio being depleted at age 86. With life expectancies approaching the late 80’s, the difference of 8 years can be the difference between having enough and having to sacrifice when you need it most.
Let’s look at one of the more significant historical examples. Consider 3 individuals each retiring on January 1st in 3 consecutive years and each had a 30 year retirement. The first retired in 1962-1991, the second in 1963-1992 and the third in 1964-1993. Assume they each retired with $1,000,000 and withdrew $50,000 annually indexed to the average inflation. You might think that their balances would all be similar after 30 years of retirement. That makes sense when you see that the average annual rate of return for a balanced portfolio (60% Equity & 40% Fixed Income), over the past 60 years, was over 8% and the average inflation rate was 3.7% and you are only taking out 5% indexed to inflation.
This is not the case!
Because the first year of retirement for the individual that retired in 1962 was negative (remember withdrawals will amplify a negative return) and significantly different from the first year of retirement of the individuals the retired one and two years after, their ending value is surprisingly different.
The purpose of this article is not to be fatalist, but to point out that if you want to truly have a secure retirement you need to consider a plan that is tested and considers multiple tools to help you grow your income and account value over time, but that also protects a minimum income in the scenario that the market does not perform in your first years after retirement.
Bryon E. Townsend, CFP® is Managing Director at W.R. Anderson & Co, LLC a Houston, TX based financial planning firm. Securities and Investment Advisory services offered through Cetera Advisors LLC, member FINRA/SIPC. W.R. Anderson & Co is under separate ownership from Cetera Advisors. The information presented above is not intended to promote any specific investment vehicle nor any specific strategy. As well it is not intended to represent financial advice. The calculations and charts were prepared from research by W.R. Anderson & Co. Registered branch address: 2190 N. Loop W., Ste 103 Houston, TX 77018
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