Sequence of Returns Impact
Regarding the sequence of returns, here are some key takeaways:
1. **Sequence of returns matters in retirement planning,** but it’s unpredictable and out of our control. The impact of market performance in the early years of retirement can significantly affect long-term outcomes.
2. **Asset allocation is crucial** for managing sequence of returns risk. A properly diversified portfolio with a mix of growth assets and safer investments can help weather market volatility.
3. **Maintaining consistent withdrawals** is important, regardless of market performance. It’s unrealistic to significantly increase spending in good years or drastically reduce it in bad years.
4. **Keeping adequate cash reserves** (1-3 years of expenses) in stable, short-term investments can provide a buffer against market downturns and reduce the need to sell assets at inopportune times.
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Sequence of Returns Impact – Transcript
Alright…
So we’re going to tackle a big question here that a lot of folks are wondering about. We meet with people in the conference room and have this discussion often. The question is: does the sequence of returns matter when it comes to retirement planning?
Let’s talk about sequence of returns first. Let’s say, for example, you have a five-year period where the market goes up 10% each year for four years, and then drops 40% in the last year. Is it better to have that 40% drop upfront and then four years of 10% gains?
The sequence of these market returns and their impact on your investments is something that people are very concerned about, especially when they’re trying to figure out the exact timing of retirement. We see this concern with people when it’s November and they’re retiring in January.
They worry about what happens if the market tanks in 2025. That could set their retirement off on a bad trajectory. Sequence of returns is definitely important, but it’s something that’s out of our control unfortunately because we don’t know when the market’s going to have a bad year.
We know that the market will have bad years, but we can’t tell you if it’s going to be in the first year of your retirement, the fourth year, or the tenth year. I think the important thing is having a discussion with people to build a plan, portfolio, and retirement income strategy that are insulated from the bad years in the market and making sure that you can survive them.
To give another illustration of this sequence of returns, I had this conversation with several people a few years back. Imagine someone calls up, unhappy with the way things are going with their investments – or with the market overall. I would say, “What if I told you that over the last three years we would average 10%?” Of course, they’re sensitive to that because they didn’t make any money at that point in the year, or they might have been down. They might say, “10%? Great!”
And I’m like, “Okay, here are the terms: First year you make 30%. The next two years you make nothing.
You’re going to average 10% a year.
Are you still okay with this?”
I think when you give people illustrations that way, they seem to understand that you can’t bank on year-to-year numbers. The long-term historical return for the last 20 or 30 years is something over 9% for stocks, but there have rarely been single years that have returned exactly 9% or whatever the historical number is.
I believe there were only four or five years since 1950 where the market has even returned 7%, 8%, or 9%. I think the study was done by Ryan Detrick with Carson Group. He’s a great follow on Twitter, by the way.
I think he even wanted to build in some wiggle room there of 1% either way around the average. So it was four or five times since 1950. We have this discussion with a lot of people too: we use average returns in our retirement plans, but there’s nothing average about it. We don’t want to bank on that. We have to assume something for market returns moving forward.
But I think something that is important for us to stress to folks is if we do have a good year like we had in 2023, it was a good year, 2024 was a good year where we have above-average market returns, does that mean that we can draw the accounts down more? Or how do we handle or address that question usually, Tim?
The firm answer is no, I’m just kidding. But you don’t want to do something like that in my opinion. If you think of it in terms of the flip side, if you take more out when the market is doing really well and you’re overperforming, does that mean that you have to live on less when the market is down? That doesn’t necessarily play out in the real world. People still have to pay their bills and their costs are what they are.
Sure, there might be some areas of the budget where they might be able to scale back if things are not doing so hot in the market, but let’s put some numbers to this. If you had drawn up a plan for someone and said, “Hey, we’re going to take out $3,000 a month or $36,000 a year, but in a good year we’re going to take $50,000, and in a poor year in the market we’re going to actually take out $18,000.”
How do you tell someone to live on less when their whole plan was based on getting $3,000 a month or $36,000 a year?
You can’t. I don’t think it’s realistic. I think on paper it might make sense in your head, but in realistic application of everyday life, I don’t think it works that way. Their costs are going to be the same whether the market’s up or down.
I think keeping it in check when the market’s going up and not spending more, those extra gains that you get in those years is what helps you be able to survive the down years. If you’re taking out all of the excess gains every year when the market’s up and then the market goes down, like we’re saying, you’re not going to live on less. That’s just not going to happen.
So I don’t think it’s realistic to take out more when the market’s up and take out less when the market’s down. I think like you said earlier, what the market gives us on a year-to-year basis is out of our control. But there are a couple of things that we can do that are within our control ahead of time.
I think one is taking the appropriate amount of risk and maintaining that through up markets, down markets, sideways markets, just taking the right amount of risk so we don’t freak out when the market’s dropping and we don’t feel like we’re missing out when markets are going higher. And the second is maintaining an appropriate cash level in your bank account.
And that could be cash in your actual bank account or short-term investments where we have one, two, three years of expenses earmarked in something short-term, something stable. That’s going to be there when we need it. And I think the idea with that is it allows you to ride out down markets knowing that you have those expenses banked and not swinging around when markets get volatile.
I agree 100%. I think that having a proper allocation saves a lot of folks from needing to have this discussion in the future. And if we put together a portfolio for someone that is, say, 70/30, we’re only going to have 70% of the investable assets in their accounts in the market at risk with the potential for growth at any time. We’re going to have 30% tucked away in something that’s hopefully less volatile, something safer that they can draw on in the event that they do need to tap into their account.
So asset allocation, “fixes” this conversation in the sense that you don’t have to worry as much about the sequence of returns – if you’ve got things properly allocated.
I’ll also add a conversation that I had recently with an organization that we manage money for. At a recent meeting, they pointed out, “Over the last two years, we’ve made $400,000 in this account.” I think the way it was posed to me was not really a question but a statement. They said, “We want to change the investments to protect our gains…”
And you guys have heard this story already, but for our viewers at home, the answer, the response was absolutely not. We’re not going to be changing things because we have an allocation set up for you so that if we do need to tap into these accounts, we do have that in this particular case 40% of the assets sitting in some super safe stuff.
So we can allow the growth side of the market to go up, down, sideways for the next two years, next three years without needing to tap into that side or make changes on that side of things. It’s really important, it’s really hard to do, but I think it’s important to not let what the market has done recently affect the amount of risk that you want to take in the account.
That should be fairly consistent across longer time horizons, which we’re usually investing for, and I think it works both ways. It works in up markets – you don’t want to take too much risk because you feel like you’re missing out, and in down markets, you don’t want to protect your losses just because the market’s going down.
I think that’s going to lead to making really poor timing decisions. And yeah, if anything, it’s usually the opposite strategy that works better. But sequence of returns is something that we can account for ahead of time. We don’t know, like you said in the beginning, exactly what’s going to happen, but there are ways that we can plan for and hopefully insulate you from getting your retirement off on a poor start. It’s something that we can hopefully plan for a little bit ahead of time and at least make mentally a little bit easier to withstand.
That’s going to do it. That’s all I got.
Alright. Cool.
Great. Thanks guys!
