Protect Your Early Retirement From Sequence of Returns Risk

So it looks like we might finally be getting that market correction we’ve all been expecting for a while. Or maybe we just saw a few random days of market flukiness. Or maybe it’s the start of the next recession. Or maybe it’s nothing. Or maybe the world is ending. Probably not, though. But maybe…

Point is: Nobody knows. If anyone can actually see the future, they’re keeping the secret to themselves. And the rest of us just have to make guesses with whatever limited info we have. And the limited info might stress out certain people. Like those who retired recently. Like us.

Because, as you probably know, for folks who save a safe amount for retirement, say somewhere between 20 and 35 times your annual expenses, the chances are overwhelmingly high that you’ll make it to the end of your life with more money than you need, maybe much much more. (Make it rain for those charities in your will, y’all.)

A small fraction, however, won’t be so lucky.

Those who draw the short straw on sequence risk, a.k.a. sequence of returns risk.

Spoiler alert: You can prepare well for sequence risk without extending your early retirement timeline, assuming you are planning on a decently safe withdrawal rate already. And if you’re not concerned about sequence risk with the markets, you might still be wise to consider sequence risk on health care costs. More on all of this farther down.

Quick Refresher On Sequence Risk

We can talk until we’re blue in the face about historical averages for the markets, but virtually no years actually yield average returns. Most years give returns below or above the mean, but they average out, like if you draw a straightish line down the middle of a roller coaster’s arc.

As Dana Anspach of The Balance writes,

Because of sequence risk, plugging a simple rate of return into an online retirement planning tool is not an effective way to plan for retirement. The online tool assumes you earn that same return each year. A portfolio doesn’t work that way. You can invest the exact same way and during one twenty year period you might earn 10% plus returns, and in a different twenty year time period you would earn 4% returns.

Because we can’t see the future, plenty of us do our math and projections based on historical averages (or perhaps lower, to be safer), which is a great way to get a rough sense of things, but it’s almost guaranteed way to be wrong somewhere, given how market returns actually play out, as well as inflation, which is a major factor in retirement success. That’s why it’s so important to have contingencies built into your plan, in addition to maintaining a mindset of flexibility. (And speaking of returns, plenty of us also overestimate likely returns because historical averages factor in reinvested dividends, and once you’re no longer accumulating, most people will cash out the dividends since you have to pay taxes on them when earned, unlike capital gains which you only pay when you sell shares. With dividends cashed out, historical averages are a significant overestimation.)

If you have average or higher than average returns in your first decade of retirement, ideally outpacing the rate of your withdrawals or share sales, then statistically, you’re golden. Those early years virtually guarantee your long-term success. But if you hit low or negative returns in those early years (and most especially if you’re projecting average returns that assume reinvested dividends)? Then you’re in the unlucky group who could possibly run out of money, even if you follow the 4% rule or another safe withdrawal rate to the letter. That’s because higher returns early mean you’re compounding on bigger numbers, and even if later returns are crappy, low returns on a big number are greater than bigger returns on a low number. As Michael Kitces says, “It’s not enough for returns to average out in the long run, if the portfolio could be completely depleted before the good returns finally show up.”

If you’re thinking, “Cool, but I’m not retiring now or soon, so this most likely won’t affect me,” here’s some sobering info: In another Kitces analysis that I highly recommend everyone read, he makes the point that a sustained sluggish or even just mediocre market (what many analysts predict we’re in for in the near and foreseeable future) is worse for sequence risk than a big crash followed by a recovery.

I’ll say that again, because it’s so important: Sequence risk is very real even with positive returns every year, if those returns aren’t big. That means all of us could be facing some discomfort here, if the sluggish next decade predictions come true.

And another wrinkle: overspending in a given year or stretch of years early in retirement can have the same net effect as hitting a bad sequence of returns because you end up potentially depleting your portfolio too much for it to recover, even with level spending and good returns in later years. The most likely cause of overspending in the near future: increasing health care costs. So even if the markets keep doing well and never stagnate or dive, if health care costs keep outpacing market gains, we’re all going to feel that effect in the form of asset depletion.

That’s all the bad news, but we’re through it now. And it’s all mitigatable, so let’s not get all nihilist about it.

(Though if you want more on sequence risk, Big ERN also has some super helpful analysis on this stuff.)

Sequence of Returns Risk Timeline

Research tells us that the most important period in terms of whether sequence risk will befall you is the first ten years of your retirement. After that, bad or mediocre returns are unlikely to hurt you so long as you stick with your safe withdrawal rate, and so long as you didn’t deplete your funds in the first decade to such a point that they simply can’t recover. However, within that important decade, the highest correlation between long-term success and market returns is in the first five years, and the steepest correlation curve of all is in the first three years. (I’m combining analysis from Kitces and ERN here, most of which is based off of Bergen analysis that undergirds the Trinity Study.)

Big ERN’s linear regression showing high importance of the first five years within the first decade:

Kitces correlation chart showing the steepest climb of correlation between annualized returns and long-term success within first three years (though high correlation over that whole first decade):

Knowing that, you can structure your retirement financial plan in such a way to minimize or even eliminate the need to sell shares of stock in those critical early years – all 10 if you want to be super conservative, five if you are medium conservative, or just the first three years if you are less conservative or if you already have a solid list of multiple contingency plans (or if you have a two-phase approach like ours and know you have fall-back money that you’re not depleting in phase 1). The whole idea is:

The longer you can keep your principle intact — shielding it from sequence of returns risk that only kicks in once you begin withdrawing — the more likely you are to have enough money to last your full lifetime.

In our case, though we definitely saved on the conservative side and know we’ve put ourselves in a solid position no matter what, we’ve been superstitious for years that we’d retire right into a recession. And while it’s way too early to tell if we’re about to hit one, we’ve been well braced for it for a long time. We’re also keenly aware that health care costs are rising much faster than inflation for everyone except those receiving the largest health care subsidies, so health care costs could turn into their own sort of sequence risk if you’re not able to scale back other expenses to accommodate rising health insurance premiums. Add all of that up, and we’ve been preparing ourselves to minimize withdrawals from our taxable stock funds – the bulk of our phase 1 savings — for the first several years of our early retirement.

And you might be wondering, “But what about safe withdrawal rates? Don’t those factor in bad sequences?” Indeed they do, to an extent. But 4% will not guarantee your success in the worst sequences, and nor will 3.5%. 3% might, based on historical data, but we also don’t have a ton of analysis on the long timelines that early retirees are looking at. And we’ve never had a time in the past that we could analyze when health care costs were rising as quickly and were as generally uncertain as they are now.

So while plenty of people may not feel the need to be as conservative as we are in our early retirement financial planning, if you can start with a lower withdrawal rate than 4% and build in some buffer against sequence risk, you can give yourself the best possible chance of never worrying about money again. All without changing your savings timeline or delaying your early retirement.

Let’s talk about how.

Related post: When the Crash Comes // Recession-Proofing Our Retirement Plans

Insulating Yourself From Sequence Risk in Early (or Traditional) Retirement

A question I think about often is whether I’d want to proceed cautiously even if the current economic cycle weren’t so overdue for correction or recession. Fortunately, much of that caution is already baked into our plan, so it’s not a choice we have to make now, or something that might have kept us working longer. It’s why our asset allocation in our taxable accounts includes a hefty dose of bonds. It’s why we have a large cash buffer. It’s why we didn’t burn any bridges on the way out of our careers. Because we may come to rely on any of those.

Here are the elements of a retirement plan that’s well girded against sequence risk, divided into allocation choices you can make as you’re accumulating your savings, and behavioral choices you can make throughout the rest of your planning.

Two Big Allocation Factors:

Invest in Low-Volatility Assets – That’s a fancy way of saying: make sure you don’t only own stock. In an extended downturn, you may be forced to sell shares, and in those cases, you’re better off being able to sell bond shares which are far less volatile than stock shares. We’re allocated roughly 70/30 stocks to bonds, and while that mix may feel too conservative or too aggressive to you, the idea is to make sure that you have something you can sell when stock markets nosedive, especially if markets take years to bounce back. Of course, make sure you’re factoring lower (or no) growth into your plans on those bonds or other low-volatility assets. If you own 30% bonds but project historical average returns on your whole portfolio, you could end up dramatically overestimating. Real estate could be another way that you achieve some balance in your portfolio and something closer to a guarantee of passive income even when you don’t want to sell off your stock shares. Whatever your preferred method of diversifying is, make sure you allocate some of your funds to assets that you can turn to when selling stock is a bad option.

Maintain a Large Cash Buffer – Every choice in life is a trade-off, and that’s certainly true with regard to maintaining a large cash cushion, e.g. multiple years worth of expenses in cash. Sure, by holding cash, you’re guaranteeing that you’ll miss out on market gains for that part of your portfolio. But you’re also guaranteeing that you won’t need to sell shares in the event of an extended market tantrum. We retired with just under three years worth of expenses in cash, which will feel like an extravagant and foolish amount if the markets keep going gangbusters, but like a wise and judicious amount if the markets start tumbling or stagnating. Again, find your own comfort level for balancing missing out on gains vs. security in a downturn, but make sure you keep a decent cushion on hand so you aren’t forced to sell when shares are down dramatically, locking in those losses permanently.

Four Big Behavioral Factors:

Make Sure You Can Dial Down Your Spending – If share prices are down and you want to avoid selling them, the best thing you can do is spend less to stretch your cash buffer. This is one area in which I’m convinced that less frugal early retirees actually have a slight leg up. (Hit up that love letter to the unfrugal folks if you need a little validation.) If you’re super frugal and your budget is already bare bones, you don’t have much room to cut when things get tight. But if your budget has a lot of wiggle room, it’s easy to cut the non-essential stuff. Likewise those who pay off their mortgages – if the markets tumble, we don’t have to worry about whether our investments are yielding enough to pay our mortgage, because we don’t have one. Not that renting or having a mortgage is the end of the world, but it does make it harder to chop your expenses dramatically if you see your investments taking a dive or flatlining. If, however, you can identify in advance a few ways that you’ll chop your spending should the need arise, say by 25-30 percent, you’ll be in a much stronger position in an extended bear market than will someone who has no good options for trimming. And related:

Be Willing to Reassess – Though the anchoring effect can be powerful and can entice us to want to keep our lifestyle at a certain level forever, if we hit a bad sequence of returns, the only way to right the ship might be to calculate a new yearly withdrawal amount that’s lower, maybe a lot lower, than where you started. That’s a risk we all need to be willing to take when embarking on early retirement, but remember there’s no risk-free life. The other alternative is risking spending all our good years on the job.

Hustle Just Enough – Our vision for early retirement has always been that we want work to be completely optional. But I’m not gonna lie – we’re both working a bit this year, and we probably will for a few years. Part of that is just that some super fun opportunities have fallen into our laps, part of it is concern about the future of health care costs, but the biggest motivator is knowing that we have better odds than plenty of other retirees of hitting bad sequence risk. So our goal this year is to earn enough to clear our annual expenses after taxes are taken out. That’s way less than we used to earn and feels totally achievable without having to work much (and while being able to be picky about what we say yes to), but it’s definitely not how we imagined we’d begin our retirement. On the flip side, though, we feel grateful to have been so keenly aware of sequence risk in our case because it’s much easier to pick up a few side gigs now, fresh out of our careers, than it would be in a few years, with cold leads. The “you can always just go back to work” notion is a lovely thought, but economic data does not bear it out. Better to keep your options open right from the beginning and earn a little in those first few years of retirement, until your gains are locked in and you’re set for life. And you certainly don’t have to hustle enough to cover all your expenses. Even reducing what you take out of your portfolio each year by 10 or 20 percent can make a huge difference in insulating you against sequence risk.

Maintain a Conservative Withdrawal Rate, At Least for a Little While – Though odds are good in a general sense that even the 4% safe withdrawal rate is unnecessarily conservative (for all but the worst sequences, 6%+ is safe), none of us know until we’re looking back in hindsight what kind of sequence we’ll hit. And given that it’s entirely possible to fail at stretching your money even at the 4% rate if you hit a bad sequence, it may pay off to start your retirement at a smaller, more conservative rate than you plan to maintain long-term. It’s what we’re doing. Our current intended withdrawal rate – assuming no extra earnings, like if we aren’t able to earn an amount equal to our expenses – is a bit under 3%. Though that’s always been the plan with our two-phase approach: live more modestly and travel more dirtbag-style in phase 1, and then step up the spending and lifestyle when we reach phase 2 when Mark turns 59 1/2. But if we get a good sequence in the first eight to 10 years, we could very well up that withdrawal rate sooner. And in phase 2, we’ll likely do the same thing: calculate a conservative withdrawal rate when we begin tapping those funds of, say, 3% and then upping it if we do well after the first decade.

Weigh In!

Alright guys, tell us all what you think! Are we seeing the start of the next recession? Just a minor correction? A total nothingburger? How are you thinking about sequence risk? Have any other strategies to head it off that you’re incorporating into your planning? Or think it’s all a myth and you’re just sticking to the 4% rule, come Hell or high water? Let’s dig into all of it in the comments!