In retirement, the sequence of returns is much more important than rates of return. The timing of gains and losses, or ‘sequence of returns,’ as it is referred to, is much more important than the rates of return. During the working years, when you are investing to accumulate money for retirement, gains and losses are anticipated and part of the accepted ‘deal’. But when you retire and begin the de-cumulation or spending down of those assets you saved, a single negative year can create a big problem, if you need some of that money to live on. It can leave you coming up short, sometimes very short… of sufficient money to live on later.
Portfolio risk is compounded or magnified in the years leading up to and throughout the retirement years. Even a small loss of 10% can potentially deplete many years of assets down the road. You save money for retirement so you have money to live on, to spend when you retire. When you spend money that has gone down in value due to market loss, that money is gone forever. You cannot get back the losses. This is what is referred to as Reverse Dollar Cost Averaging. This is expertly explained by retirement expert Moshe Milevsky in his 6 page whitepaper, Retirement Ruin And The Sequencing Of Returns. It is valuable to read it and understand it. In case you want the short version, here it is.
If you have a 401k at work, you may be familiar with the term Dollar Cost Averaging. For example, let’s assume you set aside $300 a month in your 401k. That $300 goes into your investment strategy no matter what, every month, like clockwork. That means in periods when the market is up, your $300 buys less shares. In periods when the market goes down your $300 buys more shares. The idea being, over time you have a lower average cost of all your investments because you kept buying even when things were going down and were cheap. It can be a reasonable strategy when you are in your 20’s, 30’s, 40’s, and [maybe] even early 50’s to accumulate money over time. Reverse Dollar Cost Averaging is the exact opposite. Now you are taking money out, on a systematic basis, for income to live on and the fluctuations in the market work against you, instead of help you. Imagine you are now 65 and retiring.
Here is an example. You retire at age 65, planning to live to age 90, with $500,000 in saved assets to supplement your social security. You have heard it is OK, and you feel confident spending 4% per year. The market losses 20% in year one and you took out $20,000 (4%) to live on. You have ONLY $380,000 of your $500,000 at the end of year 1. A whopping 24% of your assets are gone and you have 96% of your retirement years left to live. B I G PROBLEM! Taking withdrawals in years that your account is down in value, accelerates the decline. This puts you on a path where your only options are; continue your withdrawals at an even higher percentage now, because if you need $20,000, it is now 5.26% of the $380,000 you have left. Your only other options are to reduce your income and your lifestyle, or significantly reduce your lifestyle by taking no withdrawals until your money returns to the pre-loss values. This can and has taken 10 years or more in some periods of market turmoil. Not a fun retirement to say the least. By the way, without income guarantees, some experts are now recommending that you take only 2% withdrawals, not 4%. This MorningStar Report suggests a 2.8% rate.
Using a personal pension instead, created from some portion of your assets, your 401(k) and or IRAs is a much safer, more certain way to set yourself up for success and peace of mind. These are not affected by declining markets because you get a contractual guarantee that provides steady income for life. This gives you confidence because you will not run out of money, you have steady income no matter how long you live, market declines will not decrease that income, and your principal is protected from market losses.