Freaking Out over Sequence of Returns Risk

[bmcgonig]

That is true - however your real income may shrink to ~40% of where you started before recovering, so you have to think long and hard about how you might survive such a scenario.

If your spending projections are heavily padded with lots of discretionary spending, you might be OK. If your spending is mostly fixed, you don't have the flexibility.

Personally I keep unspent funds in short-term investments not subject to market volatility (in addition to having a lot of discretionary expenses).

With a 50/50 AA I can't imagine a drop of 40%. Even in the 2008 period it only dropped 23%. 26% in 1973/4.


http://awealthofcommonsense.com/wp-content/uploads/2015/04/50.50-II1.png

 

[audreyh1]

With a 50/50 AA I can't imagine a drop of 40%. Even in the 2008 period it only dropped 23%. 26% in 1973/4.

http://awealthofcommonsense.com/wp-content/uploads/2015/04/50.50-II1.png

Absolutely happens! Not in a single year, and not in nominal terms, but over multiple years of withdrawals, and in real income terms. Down 50 to 60%.

It's a small but real risk - pun intended.

Now it may take from 5 to 29 years or so to experience this drop. Several starting years had this occur, including 1966, in which case it took 16 years to bottom out before starting to recover.

Here I have collected the FIRECALC results with 50% total stock market, 50% 5-year treasury portfolio, and various withdrawal rates using the % remaining portfolio method.

As you can see, even for a 3% withdrawal rate, your income dropped 49% in the very worst case. For 3.5% WR it dropped 56%. You can't ignore real effects. Your spending will be in real terms.

% withdrawal remaining portfolio	average ending portfolio real	lowest ending portfolio real	highest ending portfolio real	Worst case real income reduction (1906, 1899 or 1892 run)	starting year for worst case run
6.00%	59%	30%	130%	27%	1892
5.00%	82%	41%	178%	35%	1899
4.50%	95%	48%	208%	39%	1899
4.35%	100%	51%	219%	40%	1899
4.25%	103%	52%	225%	41%	1899
4.00%	112%	56%	244%	44%	1899
3.50%	130%	66%	287%	47%	1906
3.33%	137%	69%	300%	49%	1906
3.25%	141%	71%	308%	49%	1906
3.00%	152%	77%	333%	51%	1906

To see how this looks in $ terms (still real - current dollars) which makes comparisons between withdrawal rates easier.

% withdrawal remaining portfolio	$1M starting portfolio income	$1M starting portfolio lowest income	average ending portfolio	income from average ending portfolio	lowest ending portfolio	income from lowest ending portfolio
6.00%	$60,000	$16,248	$593,418	$35,605	$298,371	$17,902
5.00%	$50,000	$17,294	$815,142	$40,757	$409,854	$20,493
4.50%	$45,000	$17,470	$954,171	$42,938	$479,758	$21,589
4.35%	$43,500	$17,481	$1,000,171	$43,507	$512,306	$22,285
4.25%	$42,500	$17,476	$1,032,020	$43,861	$518,901	$22,053
4.00%	$40,000	$17,419	$1,115,994	$44,640	$561,123	$22,445
3.50%	$35,000	$16,593	$1,304,200	$45,647	$655,754	$22,951
3.33%	$33,300	$16,210	$1,374,917	$45,785	$691,310	$23,021
3.25%	$32,500	$16,018	$1,409,464	$45,808	$708,681	$23,032
3.00%	$30,000	$15,369	$1,522,919	$45,688	$765,726	$22,972

1966 wasn't quite as bad. Income dropped 48% for someone starting using 3.5% WR, but that's still almost half, and it took 16 years to drop, from 1966 to 1981.

If someone wants to see what this looks like, do a FIRECALC run, and choose 1966, or even worse years of 1906, 1899, or 1892, and see what happened each year and how the portfolio shrinks in real terms over long periods of time.

Here are some worst case scenarios I found for the 3.5% WR case, and how long it took to drop to the lowest portfolio value.

Starting Year	No. of Years Dropping	Lowest Portfolio value (real)
1906	15	47%
1899	22	49%
1902	19	50%
1909	12	50%
1912	9	50%
1911	10	51%
1966	16	52%
1916	5	54%
1937	12	57%

You can see that some starting years - 1916! - it was fast. Other years it was a long, slow grind down. Most (in this WR) took 9 years or longer.

So - you can see why I recommend being able to handle a ~50% drop in real income. Higher WR rates had even larger drops.

 

[foxfirev5]

Then get a reverse mortgage.

Only if you're age 62 or older. Regarding HELOC's in 2009 I had a credit score over 800 and yet the bank cut my HELOC line. They explained (honestly by the local office) that they simply had to much exposure and it had nothing to do with my equity or credit standing.
I would not want to depend on this option if I really needed it.

 

[bmcgonig]

Absolutely happens! Not in a single year, and not in nominal terms, but over multiple years of withdrawals, and in real income terms. Down 50 to 60%.

It's a small but real risk - pun intended.

Now it may take from 5 to 29 years or so to experience this drop. Several starting years had this occur, including 1966, in which case it took 16 years to bottom out before starting to recover.

Here I have collected the FIRECALC results with 50% total stock market, 50% 5-year treasury portfolio, and various withdrawal rates using the % remaining portfolio method.

As you can see, even for a 3% withdrawal rate, your income dropped 49% in the very worst case. For 3.5% WR it dropped 56%. You can't ignore real effects. Your spending will be in real terms.

% withdrawal remaining portfolioaverage ending portfolio reallowest ending portfolio realhighest ending portfolio realWorst case real income reduction (1906, 1899 or 1892 run)starting year for worst case run
6.00%59%30%130%27%1892
5.00%82%41%178%35%1899
4.50%95%48%208%39%1899
4.35%100%51%219%40%1899
4.25%103%52%225%41%1899
4.00%112%56%244%44%1899
3.50%130%66%287%47%1906
3.33%137%69%300%49%1906
3.25%141%71%308%49%1906
3.00%152%77%333%51%1906

To see how this looks in $ terms (still real - current dollars) which makes comparisons between withdrawal rates easier.

% withdrawal remaining portfolio$1M starting portfolio income$1M starting portfolio lowest incomeaverage ending portfolioincome from average ending portfoliolowest ending portfolioincome from lowest ending portfolio
6.00%$60,000$16,248$593,418$35,605$298,371$17,902
5.00%$50,000$17,294$815,142$40,757$409,854$20,493
4.50%$45,000$17,470$954,171$42,938$479,758$21,589
4.35%$43,500$17,481$1,000,171$43,507$512,306$22,285
4.25%$42,500$17,476$1,032,020$43,861$518,901$22,053
4.00%$40,000$17,419$1,115,994$44,640$561,123$22,445
3.50%$35,000$16,593$1,304,200$45,647$655,754$22,951
3.33%$33,300$16,210$1,374,917$45,785$691,310$23,021
3.25%$32,500$16,018$1,409,464$45,808$708,681$23,032
3.00%$30,000$15,369$1,522,919$45,688$765,726$22,972

1966 wasn't quite as bad. Income dropped 48% for someone starting using 3.5% WR, but that's still almost half, and it took 16 years to drop, from 1966 to 1981.

If someone wants to see what this looks like, do a FIRECALC run, and choose 1966, or even worse years of 1906, 1899, or 1892, and see what happened each year and how the portfolio shrinks in real terms over long periods of time.

Here are some worst case scenarios I found for the 3.5% WR case, and how long it took to drop to the lowest portfolio value.

Starting YearNo. of Years DroppingLowest Portfolio value (real)
19061547%
18992249%
19021950%
19091250%
1912950%
19111051%
19661652%
1916554%
19371257%

You can see that some starting years - 1916! - it was fast. Other years it was a long, slow grind down. Most (in this WR) took 9 years or longer.

So - you can see why I recommend being able to handle a ~50% drop in real income. Higher WR rates had even larger drops.

REALity bites .

Thanks Audrey.

 

[mathjak107]

in the end it is real returns that count . the great depression actually recovered in under 5 years in dollar terms since the cpi fell by 18% .

dividends were not counted which were as high as 12% and many popular stocks were not in the index's yet like ibm . so between these 3 factors you were whole again in dollars in about 4-1/2 years

 

[Totoro]

+1 on that - what happened in real terms (finance-wise) during the 1930s is a story not often told.

 

[ERD50]

Absolutely happens! Not in a single year, and not in nominal terms, but over multiple years of withdrawals, and in real income terms. Down 50 to 60%.

It's a small but real risk - pun intended. .....

[see post for full tables]

You can see that some starting years - 1916! - it was fast. Other years it was a long, slow grind down. Most (in this WR) took 9 years or longer.

So - you can see why I recommend being able to handle a ~50% drop in real income. Higher WR rates had even larger drops.

Great analysis, audreyh1!

I'm always amazed at the people who just say they will make this or that adjustment, and be fine. There's only so much money there, there's no 'magic' way to stretch it out much. Yes, some w/d methods can help a bit, but no magic. But they don't do the analysis, they seem to just want to believe.

Actually, the best way to get the most out of a portfolio is with the "retire again & again" method (I think I saw another name for this in a recent post) - you adjust an inflation-adjusted 100% safe withdrawal amount up every time your portfolio allows it, and you never reduce it. What this does is has you start out conservative, and in the worst case history, you succeed. But in any thing better than worst case, you get to take out more as the portfolio grows. Because of this, you use up most of that 'excess' and leave less on the table when you pass. But it was safe for the worst case as well. Best of both worlds!

Though this can may be be pushing 'data mining' a bit too far. But you could do something in between, taking only a portion of any allowed increase.

-ERD50

 

[marko]

Actually, the best way to get the most out of a portfolio is with the "retire again & again" method (I think I saw another name for this in a recent post) - you adjust an inflation-adjusted 100% safe withdrawal amount up every time your portfolio allows it, and you never reduce it.

-ERD50

But doesn't "never reduce it" bring a level of risk? I get the "retire again and again" but I'd think in a down year you'd "retire" with a smaller WR. At least for that down cycle. No?

 

[ERD50]

But doesn't "never reduce it" bring a level of risk? I get the "retire again and again" but I'd think in a down year you'd "retire" with a smaller WR. At least for that down cycle. No?

Not historically. Remember, you start with a 100% historically safe WR, regardless of where we are in any economic cycle. So if you were on the very worst path, you still succeed. And odds are you won't be on the worst path, and so when that portfolio has grown to allow a larger withdrawal, you take it. But again, you are taking a 100% historically safe WR.

It essentially answers that paradox of the two retirees who retire a few years apart. If the second one retires and the market has risen, he gets to take a higher amount than the first retiree. Why can't that first retiree increase his withdrawal to match the new guy? The answer is, he can.

-ERD50

 

[Hermit]

I think those who are very adverse to the possibility of sequence of risk could best forestall their worries by continuing to work. Say, until they hit 70?

On the bright side, all those extra SS taxes would help prop the system up and keep my SS rolling in without any haircuts.

 

[Hermit]

Not historically. Remember, you start with a 100% historically safe WR, regardless of where we are in any economic cycle. So if you were on the very worst path, you still succeed. And odds are you won't be on the worst path, and so when that portfolio has grown to allow a larger withdrawal, you take it. But again, you are taking a 100% historically safe WR.

It essentially answers that paradox of the two retirees who retire a few years apart. If the second one retires and the market has risen, he gets to take a higher amount than the first retiree. Why can't that first retiree increase his withdrawal to match the new guy? The answer is, he can.

-ERD50

He can, but now he has exposed himself to two sequence of risk issues. That would be sort of like playing Russian Roulette.

 

[audreyh1]

Actually, the best way to get the most out of a portfolio is with the "retire again & again" method (I think I saw another name for this in a recent post) - you adjust an inflation-adjusted 100% safe withdrawal amount up every time your portfolio allows it, and you never reduce it. What this does is has you start out conservative, and in the worst case history, you succeed. But in any thing better than worst case, you get to take out more as the portfolio grows. Because of this, you use up most of that 'excess' and leave less on the table when you pass. But it was safe for the worst case as well. Best of both worlds!

Though this can may be be pushing 'data mining' a bit too far. But you could do something in between, taking only a portion of any allowed increase.

-ERD50

The only problem with the ratcheting method is that there are a few historical periods in which the retiree flat ran out of money before the thirty years was up. For example, the 1966 retiree using 4% (50 TSM/50 5-yr) ran out of money by 1989, 7 years before the 30 year duration. There were 5 scenarios from 1871 to 2015 that resulted in running out of money after 25 years.

So I guess folks tune their withdrawal rates or whatever to try to avoid these scenarios.

Personally, I prefer to let my portfolio performance drive my withdrawal rather than using automatic inflation adjustment. One advantage is that if your portfolio has a nice run up out of the gate, your income does too. You just had better prepare for a downside. We do have a huge amount of discretionary spending and we are already underspending our withdrawal now. I see this as totally doable for us, even after all of my analysis. Part of it is simply that our portfolio has grown to be larger than we "need" (knock on wood!). If someone ramped up their spending drastically to match huge initial portfolio growth - they could be caught in a painful situation when things reversed.

Well, if they can ratchet and ignore the portfolio shrinking - maybe not so painful. You have to discern wat you can live with.

 

[NW-Bound]

... It essentially answers that paradox of the two retirees who retire a few years apart. If the second one retires and the market has risen, he gets to take a higher amount than the first retiree. Why can't that first retiree increase his withdrawal to match the new guy? The answer is, he can.

-ERD50

+1

This seems like a paradox, that one can always ratchet up and still ends up OK. Why this freebie?

It's not really a freebie. The retiree who sticks with 4%WR of the portfolio low value will most likely die rich, while the one who ratchets up will more likely die with a much diminished portfolio. As long as one dies with a positive balance in his account, it is still a passing grade.

An analogy is this: a C student is just as successful as an A student, if the objective is to pass the course. Now, we can argue about why one would want to die with a big stash, but the size of the stash at death is the difference between ratcheting or not.

 

[tps7742]

I had a fear of running out of money. Last year cured me.

Lost both parents and both beloved dogs in 9 months. The year before I lost a good friend to cancer. She was 47.

Those events shook me up and made me realize that retiring young and healthy was more important to me than "running out of money".

Like you we'll never truly 'run out' due to our income streams but last year made me realize that if things get tight i would rather work later in life, which is a maybe, than give up the freedom I have right now, which is a certainty.

The words in this post says it all imho!!

 

[ERD50]

He can, but now he has exposed himself to two sequence of risk issues. That would be sort of like playing Russian Roulette.

No, because if two sequence of returns like that are in the history, this withdraw amount succeeded those as well.

The only problem with the ratcheting method is that there are a few historical periods in which the retiree flat ran out of money before the thirty years was up. ...

That is why I always specify "using a 100% safe historical amount". There are no failures. I'd need to look it up, but for a 40-45 year period, I think 100% safe WR was ~ 3.25%.

-ERD50

 

[marko]

Not historically. Remember, you start with a 100% historically safe WR, regardless of where we are in any economic cycle. So if you were on the very worst path, you still succeed. And odds are you won't be on the worst path, and so when that portfolio has grown to allow a larger withdrawal, you take it. But again, you are taking a 100% historically safe WR.

-ERD50

I'm still not getting your "never reduce it" part. If my portfolio balance dropped significantly and I ran a 'retire again' profile, even with a 100% safe WR, the amount would be reduced from the previous (higher portfolio amount) run.

Agreed, I wouldn't run out of money but only if I were to reduce the amount.

What am I missing?

 

[RobbieB]

I have no fear of sequence of returns. I have a very low overhead. I could "squeak by" on 30 grand a year.

But a hundred grand a year is a lot more fun!

 

[audreyh1]

I'm still not getting your "never reduce it" part. If my portfolio balance dropped significantly and I ran a 'retire again' profile, even with a 100% safe WR, the amount would be reduced from the previous (higher portfolio amount) run.

Agreed, I wouldn't run out of money but only if I were to reduce the amount.

What am I missing?

You don't run the 'retire again' profile when your portfolio goes down. Only when it goes up! Otherwise you take the prior year income and adjust it for inflation to determine your new withdrawal.

This is the "ratcheting up" method. The idea is to keep ratcheting up until you run into a down year. And thereafter switch to the inflation adjusted mode until the portfolio starts rising again. Theoretically, if you have picked a 100% safe rate, you probably won't run out of money (according to history), even if you deplete your portfolio after 30 or 40 years or whatever you picked to determine your SWR.

This is efficient in that it deliberately seeks a "bad sequence of returns" scenario in the interest of taking withdrawals as large as possible and spending down the portfolio as much as possible. This takes some intestinal fortitude.

Otherwise, in most cases, the "constant spending" model leaves behind a huge portfolio at the end of the period meaning that the retiree wasn't spending nearly as much while living as they could have.

 

[marko]

You don't run the 'retire again' profile when your portfolio goes down. Only when it goes up! Otherwise you take the prior year income and adjust it for inflation to determine your new withdrawal.

This is the "ratcheting up" method. The idea is to keep ratcheting up until you run into a down year. And thereafter switch to the inflation adjusted mode until the portfolio starts rising again. Theoretically, if you have picked a 100% safe rate, you probably won't run out of money (according to history), even if you deplete your portfolio after 30 or 40 years or whatever you picked to determine your SWR.

This is efficient in that it deliberately seeks a "bad sequence of returns" scenario in the interest of taking withdrawals as large as possible and spending down the portfolio as much as possible. This takes some intestinal fortitude.

Otherwise, in most cases, the "constant spending" model leaves behind a huge portfolio at the end of the period meaning that the retiree wasn't spending nearly as much while living as they could have.

Ahhhh!!! Got it!

So a $1MM portfolio (for example) might yield a $34K WD in year one.
Year two: Portfolio/market is down to $850K but because a 100% success was calculated you still stay with the $34K WD
Year three: Portfolio at $900K...up, but not above the $1MM so again you stay with the $34K amount (plus inflation)
Year four: Porfolio at $1.2MM and you again recalc...

Right?
Thanks!!

 

[pb4uski]

^^^^^ Yup.(Other than the year 2 WD would also be adjusted for inflation). It is just as if you retired at the beginning of year 4 with a $1.2 million portfolio.

 

[audreyh1]

Ahhhh!!! Got it!

So a $1MM portfolio (for example) might yield a $34K WD in year one.
Year two: Portfolio/market is down to $850K but because a 100% success was calculated you still stay with the $34K WD
Year three: Portfolio at $900K...up, but not above the $1MM so again you stay with the $34K amount (plus inflation)
Year four: Porfolio at $1.2MM and you again recalc...

Right?
Thanks!!

Right, like pb4uski says for year 2 and 3 you will be increasing $34K by inflation each year, so if the portfolio value in year 4 exceeds your starting value increased by inflation for the last three years, then you can ratchet up. Otherwise stick with the prior year income + inflation.

 

[GravitySucks]

Right, like pb4uski says for year 2 and 3 you will be increasing $34K by inflation each year, so if the portfolio value in year 4 exceeds your starting value increased by inflation for the last three years, then you can ratchet up. Otherwise stick with the prior year income + inflation.

Hmmmm. Taking this a step further, I think you could ratchet up the rate even further as after ten years you would only need a 30 year SWR which is slightly more and after 20 years only need the 100% SWR for 20 years.
Now I just need to look for that expiration date that's stamped on me...

 

[marko]

Hmmmm. Taking this a step further, I think you could ratchet up the rate even further as after ten years you would only need a 30 year SWR which is slightly more and after 20 years only need the 100% SWR for 20 years.
Now I just need to look for that expiration date that's stamped on me...

In 15 years, I'll be 80. I wonder if you can run it backwards: Run the first 15 years with a 15 year SWR then run the balance with a 30 SWR.

 

[mrWinter]

The best news is that as she is a retiree from state government, we have health and dental insurance for life at about $100/Month.

What state is this, and how long did you have to work there to get that benefit? Is this still offered or is this an artifact of the good old days? Perhaps I'll move my family tomorrow... sounds like an amazing deal.

 

[marko]

Right, like pb4uski says for year 2 and 3 you will be increasing $34K by inflation each year, so if the portfolio value in year 4 exceeds your starting value increased by inflation for the last three years, then you can ratchet up. Otherwise stick with the prior year income + inflation.

Thanks for the clarifications! This sounds considerably easier to manage and somewhat safer.

Running the numbers however, it seems that regardless of strategy as long as one keeps their WR in a 3.4% to 4.2% range any approach gets the job done.

Reminds me of an early job I had in the '70s doing repair cost estimates for high tech equipment. Every repair cost was between $1200 and $1325 and it took hours to figure out an exact price. I finally convinced management that it would be cheaper/better/faster to just charge everyone $1275 and not do the evaluations.