While we tend to emphasize accumulating retirement savings (for good reason), how you withdraw and spend that money in retirement is equally important. How much you withdraw, and from which accounts, can all impact how long your money may last. One lesser-known risk for retirement income—sequence risk—is particularly relevant when markets are volatile. So what are sequencing and sequence risk, and how might they impact your withdrawal strategy in retirement?
A note on performance data
The S&P 500® returns about 10% per year on average. And while that metric is helpful to keep in mind big picture, it’s flawed for a number of reasons. To start, an average return doesn’t mean it returns 10% each year—some years, it might go up 20%; other years, it might fall 15%; and so on. In addition to that, it’s rare to have money invested in the S&P 500® only. We always recommend a diversified portfolio. The three primary building blocks tend to be stocks, bonds, and alternative investments. (We also include a cash allocation but are not listing that here.)
While the S&P 500 isn’t necessarily the best benchmark to use when talking about a diversified portfolio, it’s often the easiest way to illustrate concepts tied to investment performance. (Plus, we prefer to use real-world examples to show these concepts at play versus academic hypotheticals.)
Withdrawing money in retirement
Many folks think that if the market returns roughly 10% a year, they’ll be able to withdraw 10% of their portfolio each year for income in retirement. However, that’s not the case, due in part to the reasons we just discussed. For a portfolio that’s made up of 50% stocks and 50% bonds, the general rule of thumb is to expect to withdraw 4% of your money each year in retirement.
In addition, it can be challenging to think of this amount in a percentage instead of dollars. Say you have a $2 million portfolio and want to draw 4%. That would give you $80,000 for your first year of retirement. But, if the market closed flat the following year, the next time you withdrew 4%, you’d have just $76,800, or 4% of $1,920,000.
For that reason, we’re going to look at withdrawals from a more practical standpoint: in dollar terms. That means if you plan to withdraw $80,000 each year, that might be 4% one year, 6% another, 3% another, and so on. All of this plays a role in how long your money will last. Particularly, when we start talking about sequencing—or the sequence of returns.
Timing matters
While it’s ideal to buy low and sell high, that isn’t always possible, particularly in retirement. When you need those investments as income, you may be forced to sell low, during a market downturn.
Market downturns are inevitable, but it turns out that when those downturns occur has a big impact on your money. In other words, the sequence of returns—what order you see down years and up years—matters significantly when it comes to having enough money in retirement.
To show what we mean, consider the same 20-year period taken in two different orders. The chart on the left represents actual returns for the S&P 500 between 2000 and 2019, where big losses associated with the dot-com bust occur in the first two years. When those same returns are taken in reverse order—in other words, the sequence of returns is different—there’s a significant change to the account balance 20 years on. This, despite the fact that the average return is the same for both periods.
How this impacts retirement income planning
Being aware of the risk the sequence of returns can pose to your retirement is one thing. Planning for it is another. At Bogart Wealth, we use a Monte Carlo analysis to look at how your portfolio may perform in different market scenarios. Once we see how different market events or volatility might impact your portfolio, and therefore, your retirement income, we may be able to adjust your investments or your overall income strategy in retirement.
It’s worth noting that this simulation reviews variations on possible market returns, but it won’t account for your personal spending habits or other sources of retirement income.
Other considerations
Your lifestyle in retirement doesn’t need to depend exclusively on investment performance. For instance, you may be able to tap into alternative sources of income if your portfolio loses value. In some cases, credit can be a helpful tool. Similarly, Social Security or an employer-sponsored pension benefit can help as well.
We do also look at how we can adjust your portfolio to accommodate big swings in the market. Once you hit retirement, we tend to think about your portfolio in terms of “buckets.” One bucket stays focused on growth to help ensure your money lasts. Another might focus on cash equivalents, which you can use when you don’t want to “sell low” on your other investments. How we design and think about these buckets will depend on your personal circumstances.
A few final thoughts
As you consider how much you’ll need in retirement, here are a few final thoughts that are in addition to the information shared above:
- Healthcare costs can play a big role in how much money you’ll spend in retirement, especially if you’re retiring before Medicare eligibility.
- It’s not unusual to spend 30+ years in retirement nowadays. With longer life expectancies, the need to consider sequence risk and develop a withdrawal strategy is greater than ever.
At Bogart Wealth, we help you review all aspects of your finances to create a withdrawal plan that meets your needs in retirement, regardless of market conditions. These may include evaluating your potential sources of income, the timing of your retirement, the allocation of your investment accounts, anticipated expenses, market outlook and more.
