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.