Wow! Even Tom Brady is returning to work after experiencing a series of return risks after retirement. Playing in the NFL for 23 years is a lot. At 44, I hope he doesn’t injure himself. I’m retired so let’s keep the topic going.

Sequence of return risk refers to the risk of lower or negative returns early in a period when withdrawals are made from an investment portfolio. Withdrawals are made from an investment portfolio, usually during times of financial constraint or, more traditionally, during retirement.

If you happen to retire before a bear market hits, you run the risk of sequencing returns. Therefore, it is generally better to retire near the bottom of a bear market rather than near the top of a bull market.

If you retire near the bottom of a bear market, your finances have already been put to the test. Chances are good times will return while you are still unemployed.

What is the order of returns?

If you plan to eventually retire, you need to be aware of the risk of the sequence of returns.

Also called sequence risk, this is the risk that arises from the order in which your investment returns occur. Sequence of return risk is the risk that the market will decline in the early years of retirement, combined with ongoing withdrawals.

If your retirement portfolio falls by 10-20% and you withdraw at a rate of 4% or higher, this combination can significantly shorten the life of your portfolio. Because of the risk in order of return, it’s important to have a more conservative portfolio as you get closer to retirement. Once you retire, capital preservation becomes even more important.

The people who had most of their wealth in stocks in 2007 and 2008 were shaken awake. Many probably had to postpone their retirement for years. Or they just couldn’t spend and do that much in retirement.

Here is my recommended proper asset allocation of stocks and bonds by age. You will notice how stock allocation decreases with age and bond allocation increases with age. Bonds are defensive investments that tend to outperform stocks when stocks fall.

If you also invest in real estate and alternative investments, check out my recommended asset breakdown by age. This article provides a more complete picture of how to counteract risk in order of return.

How to reduce the order of returns?

The easiest way to reduce the risk of sequencing returns is to lower your safe withdrawal rate during bad years. In fact, try to live on the safe withdrawal rate of FS for the first two or three years of retirement, even when times are right. This will help you live on less when the next downturn inevitably comes.

The concept is similar to paying yourself first by automatically contributing the maximum you can to your 401(k) or IRA at each paycheck. You learn to live on less.

Lowering your withdrawal rate in retirement is something you can control. You can also change your asset allocation to be more conservative before a down market kicks in. However, once a bear market hits, changing your asset allocation may already be too late.

An alternative solution for countering the return risk is to generate a supplementary pension income. For example, you can start a minimum wage job, advise, teach piano, or make money online. Or you can do what a Financial Samurai reader did and get his old job back, but in a part-time capacity.

In other words, even if your investment returns begin to decline after you retire, you can offset the negative effects of losing money. Any supplemental retirement income you generate will help lower your withdrawal rate. Furthermore, it can also help you to buy more investments cheaply.

Finally, the good times return. Your goal is to remain a retiree until that time comes. In the meantime, do everything you can to survive.

Sequence of returns Risk examples

Here are two examples of the risk of the sequence of returns.

Sequence of returns Risk examples

In both scenarios, the S&P 500’s returns are identical, except they are in reverse order. As a result, the compound annual growth rate (CAGR) of each scenario is the same.

Scenario A is what most retirees prefer. Good returns for three years, followed by two years of bad years. Reducing your safe withdrawal rate for the first three years will help you withstand negative returns in Years 4 and 5. In addition, as you get older and richer, your asset allocation should become more conservative, which will help you lose the less money.

Scenario B is the nightmare scenario for new retirees. As soon as you hang up your boots, your retirement portfolios begin to be crushed. It’s stressful enough to retire after so many years. But to then experience a bear market can really scare you. You are less likely to be more aggressive in your investment portfolios in year three and beyond to recoup your losses.

The key to surviving the painful scenario is to lower your withdrawal rate and generate additional income so that you are not forced to sell your investments after a big drop. Ideally, you can also generate enough passive income to invest more during the recession.

The 4% rule is too aggressive due to the risk of the order of returns

The 4% rule was invented in 1994 by Bill Bengen. He found that an initial withdrawal rate of 4% of a portfolio, with distributions adjusted for inflation each year thereafter, yielded at least 30 years of income. The 4% rule even worked for individuals who retired just before significant bear markets.

However, we no longer live in the 1990s, when the 10-year yield was between 5% and 7%. Interest rates are much lower, meaning dividends, rental income, and other income streams are also lower. Furthermore, expectations for investment returns over the next 10 years have all fallen. As a result, we will have to accumulate more capital to generate a comparable amount of income.

I recommend that you don’t pick up at 4% when the 10-year yield is at 2% and we’ve been through a prolonged bull market since 2009. Furthermore, high inflation is also hurting the purchasing power of retirees.

Even Bill Bengen mentioned in a comment on this site that he is steadily earning supplemental retirement income through consulting. Generating additional income once you’re out of a day job is key to surviving risk in order of return.

In my case, I generate supplemental pension income online through advertising income on this website. I like to write and talk about personal finance in my podcast.

As a result, I’ve found my ideal combination of doing what I love and getting paid for it in a fake pension. I just have to be careful not to spend more than 20 hours a week online. Otherwise it starts to feel like work.

Sequence of returns, risk and stagflation (2022+)

The worst case scenario for retirees is experiencing negative returns on the pension portfolio and high inflation. Stagflation refers to slower economic input and high inflation. The combination of high inflation hurting a retiree’s purchasing power and negative portfolio returns is one of the worst-case scenarios for retirees.

2022 will be a year of possible stagflation. If stagflation doesn’t come in 2022, it could come in 2023. As a result, it is vital for retirees today to be more careful with their withdrawal rates. The last thing you want to do is lose a ton of money and get back to work.

Other risky times from the past are the years 1929, 1933 and 1966. Study history so that you can experience a similar bad fate as little as possible.

Sequence of Returns Risk Can Crush Your Retirement Dreams

Ever since I faked retirement in 2012, some readers have commented that I’m too conservative with my investments and my investment outlook. Well, of course, because I thought I had collected enough to be happy. But things changed as my ambitions for a family grew. Since I left, most of my assets have been invested in risky assets to varying degrees.

However, as someone who was in Asia during the Asian financial crisis of 1997, went through the Dotcom bubble of 2000, and had significant assets during the global financial crisis of 2008-2009, I have some experience. And the good thing about going through a lot of pain is that subsequent painful events tend to hurt less.

Once you’ve made enough money to never have to work again, you need to protect your capital. You’ve already won the game, so stop running so fast. You could sprain your ankle or worse!

Last order of returns Risk example

To help you get back to Earth, here’s a final sample return risk sequence from the Retire One website. It shows how a retiree at the beginning of a bear market has 65% less after 15 years. The downward market returns of between 5% and negative 15% aren’t even that bad!

The problem is the consistently high withdrawal rate of 5.55%, starting in year one to a withdrawal rate of 14% in year 15. Hopefully none of us are so robotic that they are withdrawing faster and faster as the markets fall.

The other problem is five consecutive years in the market after you retire. That’s real misery right there. Fortunately, this is unlikely to happen based on historical returns. Three straight years of decline is the worst we can really expect.

More Sequence of Returns Risk Examples

The result is that after 15 years of retirement, the retiree still has 35% of his original pension portfolio left. Not bad if you retire at 65. You don’t want to die with too much money. Otherwise, you’ve wasted all this time collecting that money.

But if you had retired earlier, let’s say age 50, then you’re only 65 years old. Therefore, it is up to you to find the right way to best reduce your wealth, invest and spend your money. I actually have a message about decumulation coming up.

The best way to counter the risk of sequencing returns is to start with a low withdrawal rate and work your way up slowly. The goal is to fund any investment overruns to help you weather recessions. Of course, if you’re retiring right before a big bear market, you can always try to get your old job back like Tom Brady until the good times return.

Reader questions

Readers, how are you prepared for the risk of sequencing returns? Is stagflation the worst-case scenario for new retirees? Worried about sequence risk as bear markets seem to last shorter than the two-year average these days?

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