Clients nearing retirement and worried they might outlive their savings may focus on what will happen if the stock market crashes as soon as they leave the workforce.
What the market does the year someone retires, however, is less important than how it performs over the next decade, according to Michael Kitces, chief financial planning nerd at Kitces.com and head of planning strategy at Buckingham Wealth Management.
Slow market recoveries or extended stretches with low returns can have a magnified effect on retiree wealth over time, and volatility plays a role as well, he said last month at Charles Schwab's Impact 2023 conference, where he discussed sequence of returns risk.
The sequence of market returns matters greatly and can cut both ways, Kitces told advisors. A good first decade will allow investors to "blast so far ahead" that a major downturn late in their retirement "is basically just a speed bump" on the way to octupling assets after 30 years.
With a bad first decade, however, "you can dig a hole so deep you can't recover," Kitces said, noting that the inflation rate makes a big difference as well.
Two clients with the same $1 million portfolios and the same 10% average stock returns over 30 years, both with 5% bond returns, won't have anywhere near the same outcomes if the sequences of stock market returns are flipped, Kitces explained.
In other words, a client will have significantly different results if the stock market returns 0% in the first two years and 20% in the last compared with the outcome for a client who experiences a stock market with a 20% return in the first two years and 0% in the last — even though the market returns average 10% for both over 30 years.
The client with 20% stock returns in the first two years will never have to touch the principal; if there's a downturn at the end, the client will just end up with less excess wealth than if there hadn't been, Kitces noted.
The client who experienced 0% returns in the first two years, in contrast, will quickly have to chip into principal and likely run out of funds before the 30 years have passed, never getting the chance to catch up and experience any big market gains in the last two years, he explained.
As for inflation's effect, Kitces said, "Plus or minus half a percent inflation is a nine-year swing on the survival rate for a 30-year portfolio."
Citing the 30 years from 1969 through 1999, Kitces said, "by any measure this was an absolutely amazing time to be an investor," with the average portfolio returning 11.5%. Inflation ran at 5.3%, he said.
In theory, given the market returns, an investor could safely withdraw 7.4%, or about $74,000, in those years. Given inflation, however, "you're flat broke in 12 years," Kitces said, adding that the $74,000 lifestyle grows to nearly $350,000 by the end due to inflation.
"It doesn't matter if you get returns in the long run when you don't have enough money left," Kitces said.
So how do advisors help clients defend against "sequence of return" risk?
Safe withdrawal rates, dynamic asset allocations and dynamic spending strategies can help manage the risk, Kitces said. A key message: Conservative withdrawal rates in the early retirement years can significantly improve long-term results.
Safe Initial Withdrawal Rates
The much-discussed guideline recommending a 4% initial withdrawal rate was taken from research looking at what it would take for a portfolio to withstand the worst 30-year sequences of returns in market history.
That research, covering retirements starting in the years 1871 to 1982, shows 4% as a safe rate for the worst year, 1966, after which the stock market showed no appreciation for 15 years, Kitces said.
Assume a new retiree has a $1 million portfolio balance with a 4% initial withdrawal rate — a $40,000 spending withdrawal in the first year. After that, the retiree never looks at the percentage again and simply withdraws $40,000 a year, adjusting the amount for each year's inflation, he explained in an email.
So the client would spend $41,322, or whatever the inflation adjustment would be, and so on for each subsequent year.
Looking at historic returns, a 1966 retirement saw the only 30-year sequence in which starting with $40,000, and adjusting spending for each year of actual inflation — while the portfolio moved up and down with stock and bond returns — resulted in the person spending down a retirement nest egg over the 30 years, according to Kitces.
