Sunday 25 August 2024

Sequence of Returns Risk affecting Portfolio withdrawals

I have attended several sessions by Financial Planners discussing the financial plan for Retirees during their retirement years. The conversations usually center around the return on investment, inflation and amount of systematic withdrawal. An oft ignored part of the discussion is the sequence in which the returns are expected to be received. This is a key aspect of the financial plan for the retirement years, since it has a substantial impact on the principal used to earn periodic returns. Without further ado, let me go straight to the numbers to elaborate my point.

I have considered two scenarios below:

1.    Scenario 1: A Systematic Withdrawal Plan for 20 years - a retiree who experiences returns @ 5% for the first 10 years and 10% returns for the next 10 years of retirement.

2.    Scenario 2: A Systematic Withdrawal Plan for 20 years - a retiree who experiences returns @ 10% for the first 10 years and 5% returns for the next 10 years of retirement.

Scenario 1

Scenario 1

Year

Principal 
(A)

Withdrawal 
(B)

Portfolio remaining 
C=(A-B)

Returns %

D

Returns 
E=C*D

Closing Balance
C+E

1

10000000

1000000

9000000

5%

450000

9450000

2

9450000

1000000

8450000

5%

422500

8872500

3

8872500

1000000

7872500

5%

393625

8266125

4

8266125

1000000

7266125

5%

363306

7629431

5

7629431

1000000

6629431

5%

331472

6960903

6

6960903

1000000

5960903

5%

298045

6258948

7

6258948

1000000

5258948

5%

262947

5521895

8

5521895

1000000

4521895

5%

226095

4747990

9

4747990

1000000

3747990

5%

187400

3935390

10

3935390

1000000

2935390

5%

146769

3082159

11

3082159

1000000

2082159

10%

208216

2290375

12

2290375

1000000

1290375

10%

129038

1419413

13

1419413

1000000

419413

10%

41941

461354

14

461354

1000000

-538646

10%

-53865

-592511

15

-592511

1000000

-1592511

10%

-159251

-1751762

16

-1751762

1000000

-2751762

10%

-275176

-3026938

17

-3026938

1000000

-4026938

10%

-402694

-4429632

18

-4429632

1000000

-5429632

10%

-542963

-5972595

19

-5972595

1000000

-6972595

10%

-697260

-7669855

20

-7669855

1000000

-8669855

10%

-866985

-9536840

 

As evident from the table above, an individual earning 5% returns for the first 10 years and 10% returns subsequently will run out of money by year 14, assuming a fixed withdrawal of 1,000,000 every year.

Scenario 2

Scenario 2

Year

Principal 
(A)

Withdrawal 
(B)

Portfolio remaining 
C=(A-B)

Returns %

D

Returns 
E=C*D

Closing Balance
C+E

1

10000000

1000000

9000000

10%

900000

9900000

2

9900000

1000000

8900000

10%

890000

9790000

3

9790000

1000000

8790000

10%

879000

9669000

4

9669000

1000000

8669000

10%

866900

9535900

5

9535900

1000000

8535900

10%

853590

9389490

6

9389490

1000000

8389490

10%

838949

9228439

7

9228439

1000000

8228439

10%

822844

9051283

8

9051283

1000000

8051283

10%

805128

8856411

9

8856411

1000000

7856411

10%

785641

8642052

10

8642052

1000000

7642052

10%

764205

8406258

11

8406258

1000000

7406258

5%

370313

7776570

12

7776570

1000000

6776570

5%

338829

7115399

13

7115399

1000000

6115399

5%

305770

6421169

14

6421169

1000000

5421169

5%

271058

5692227

15

5692227

1000000

4692227

5%

234611

4926839

16

4926839

1000000

3926839

5%

196342

4123181

17

4123181

1000000

3123181

5%

156159

3279340

18

3279340

1000000

2279340

5%

113967

2393307

19

2393307

1000000

1393307

5%

69665

1462972

20

1462972

1000000

462972

5%

23149

486121

 

Again, as evident from the table above, an individual earning 10% returns for the first 10 years and a lower 5% returns for the subsequent years will still have money unused at the end of year 20.

Timing Matters

Sequence risk revolves around the timing dynamics in investment returns. Simply put, if a portfolio experiences lower returns when withdrawals are happening, it can have a lasting and adverse impact on the portfolio's value. This is because there are fewer monies left to benefit from potential market recoveries in subsequent periods. Conversely, higher returns in the early stages of retirement can positively influence the longevity of a portfolio, especially if the early portfolio balance is high.

This makes it incumbent on individuals to possibly target her/his retirement in periods of better market conditions or take remedial measures or completely delay retirement in case of unfavorable market conditions.

Some of the remedial measures may include keeping a reserve to tide over periods of lower returns, especially early in the retirement period or simply scaling back on the withdrawals in the early years of retirement.