There’s a lot of jargon in the world of personal finance. The more terms you know, the more comfortable you’ll be when it comes to making decisions about your money. Today’s post is meant to be a short and sweet tutorial about the basics of Sequence of Return Risk.
A bear market is one where overall stock market returns are falling.
A bull market is one where overall stock market returns are rising.
This distinction is very important.
Retiring into a Bear Market
Let’s say you retire with $1,000,000. You plan to live on $40,000. So long as your portfolio is kicking off atleast 4%, then you’re golden for as long as you live. Hooray!
You retire. You smash your alarm clock. You wake up when you want with a smile on your face. The only fly in this ointment is that you’ve retired at the start of a bear market. The value of your portfolio drops 15%, which means your portfolio is now worth $850,000 (= $1,000,000 x [1-0.15]).
Your portfolio is still kicking off a return of 4%, but you’re not getting $40,000 per year anymore. With a portfolio of $850,000, you’re only getting $34,000 (=$850,000 x 4%). Where will the other $6,000 come from? Remember, you need $40,000 to fund each year of your retirement.
You’ll have to withdraw the extra $6K from your portfolio balance of $850,000, leaving you with $844,000 (= $850,000 – $6,000). That’s still a decent chunk of change, but eating into the principal had not been part of your retirement plan…
Year 2 of retirement isn’t exactly great either. The bear market is easing, but it’s still a factor. The value of your portfolio drops another 10%. (Yes, it’s possible for the stock market to drop two years in a row.) That $844,000 that you had is now down to $759,600 (= $844,00 x [1-0.10]). Yikes! That’s $240,400 less than what you started with when you first retired.
Yet you still need $40,000 per year to live on, and your portfolio is still kicking off 4%. Sadly, 4% of $759,600 is $30,384… which is $9,616 (= $40,000 – $30,384) short of your needed $40K. So where will that $9,616 come from? You’ll have to take it from your $759,600….dropping your portfolio balance back down to $749,984 (=$759,000 – $9,616). Not good!
Year 3 of retirement welcomes the return of a bull market, and the stock market goes up 7%. Hooray! Your $749,984 is now worth $802,483 (=$749,984 x 1.07). That’s still not enough to kick off $40,000. In fact, your portfolio will only earn you $32,099 (=$802,483 x 4%), which means taking a further $7,901 (= $40,000 – $32,099) from your portfolio.
Do you see the problem?
When you retire into a bear market, your retirement portfolio might not be sufficiently large to cover your anticipated expenses. You may be forced to withdraw money to cover your living expenses when the value of your portfolio has dropped!!! This is a very bad thing because it means that your money won’t be invested when the stock market invariably starts increasing again.
Retiring into a Bull Market
However, if you retire into a bull market, then things are considerably better. Starting with the same assumptions of a $1,000,000 portfolio, a 4% return, and annual expenses of $40K in retirement, check out what happens if the stock market goes up 7% in the first year.
Your portfolio is up to $1,070,000 (=$1,000,000 x 1.07). At 4%, that means your portfolio is kicking off $42,800 (=$1,070,000 x 4%). Yet, you don’t need more than $40,000, so you leave the $2800 invested. Now your porfolio is worth $1,072,800 (=$1,070,000 + $2,800).
In year 2, the market goes up another 15%. Your portfolio goes up to $1,233,720 (=$1,070,800 x 1.15). At 4% return, you’re receiving $49,349 (=$1,233,720 x 4%). Again, you take out the $40K that you need and you let the $9,349 continue to stay invested. Now, your portfolio is worth $1,243,069 (=$1,233,720 + $9,349).
Year 3 is another positive year, though not as positive as year 2. The stock market only produces an average return of 5%, generating $62,153 (= $1,243,069 x 1.05) for you. You don’t change your spending, $40K goes into your spending account and the remaining $22,153 stays invested. Now your portfolio is worth $1,265,222 (= $1,243,069 + $22,153).
See the difference? Retiring into a bull market means your portfolio will continue to grow, so long as you don’t spend every penny of your returns.
Protecting yourself from the sequence of return risk
Like I said at the start, this is just a short tutorial on the sequence of return risk. Other persons far wiser than I have spent way more time coming up with great strategies. One of the books that I would strongly suggest you read for a more in-depth analysis on this topic is Quit Like A Millionaire by Kristi Shen & Bryce Leung. Their book offers a brilliant strategy for avoiding the sequence of return risk – it’s called the Yield Shield and it’s awesome. Another great source of information about how to avoid sequence of return risk is this article from The Retirement Manifesto.
And if you really want to sink your teeth into this topic, check out Big Ern’s Safe Withdrawal Rate series at Early Retirement Now.
If you’re not able to avail yourself of the Yield Shield, then another way to make up for the shortfall between when you need and what your smaller portfolio can provide is to get a job. I’m not suggesting a return to full-time work, but maybe you’ll have to find a part-time job that generates $10,000 per year. A part-time income of $10,000 per year would definitely cover the shortfall in year 1, which means leaving your money invested so that it can grow when the stock market returns start becoming positive again.
And if you’re deadset against part-time work, then there’s always the option of cutting your expenses to live on whatever your portfolio generates. This isn’t the preferred option for a few reasons. First, it’s never fun to cut out the little extras that make life a bit more pleasant. Secondly, there’s only so much you can cut. Thirdly, there’s no room for surprise expenses like a new furnace in the dead of winter. While it’s not ideal, working a few hours a week might be a better financial alternative for you than cutting out expenses that make the non-working hours more comfortable.
So that’s my primer on the sequence of return risk. Retiring into a bear market is fraught with peril, but there are ways to minimize its negative impact on the sustainability your long-term retirement money. It’s best to retire into a bull market. Should you not be one of the people with an accurate crystal ball able to tell you what the future will bring, then I suggest that you read and learn more about how to ensure that your retirement portfolio lasts for as long as you do.