The Greatest Threat to Your Life Savings – Sequence of Returns

The Greatest Threat to Your Life Savings

Season's greetings, everyone, and happy holidays. Welcome to the Retired-ish podcast. I'm your host Cameron Valadez, and today we are talking more about retirement savings and investments, which most of us would actually consider our life savings or our retirement nest eggs.
In the last episode, we talked about how to construct a retirement portfolio and what are some of the different things that we'll want to consider. And this time, we will be talking more about how to manage that investment portfolio when we need to begin spending from it or cracking the nest egg.

When you get to this point in your journey, you will find out very quickly that this phase is much more complicated than the working and saving phase. While you're working and saving, things are fairly simple, you just keep plugging away, socking away money, and you're still generating income from your job or your career. So, there's a little bit of extra safety there. If your investments don't perform well in a given year, you still have the benefit of saving more money on a consistent basis and, therefore, typically getting a better average price on your investments. So, it's not the end of the world.

But once that income is either gone or drastically reduced because you left the workforce or work part-time instead, you now have to rely on yourself to generate the necessary income to carry out your desired lifestyle. Now, not only is this incredibly nerve-wracking, but it makes you second guess nearly every decision you make around your money. It's strange to all of a sudden start spending and using money from your life savings and begin to see it deplete. Mentally, this can be very challenging. Am I spending too much? Too little? Will I run out of money early? What if my spouse or I get really sick and have a lot of out-of-pocket medical expenses? Will I have to re-enter the workforce and compete with younger blood? I mean, these are some of the thoughts that can begin to consume you and drive you crazy over time.
Then there's the performance of your investments. This is something that, to a large degree, you have no control over, and on top of that, you're typically not adding any more money to the pot, so to speak, so it adds even more complexity and anxiety to your situation. However, we know that we need to invest at least somewhat in retirement during retirement so that, at a minimum, our money can aim to keep up with inflation, not to mention our own individual lifestyle needs over a 20 to potentially 30-year retirement.
Now, I don't say all of this to scare you, I promise. You just need to be aware of the very real risks that you likely will encounter at some point on your journey. Don't stress too much because I'm gonna tell you how to prepare yourself for when that time comes. All that's left for you to do is find out a way to take action. So let's get into it.

This spending phase or distribution phase of retirement, when you crack the nest egg, is where significant risks and threats can sneak up on you. The transition from saving to spending is where you'll find the greatest threat to your life savings, and that is something called the sequence of returns risk. If you only take one single thing away from today's show, it's to know that sequence of returns risk is a real threat that can work against you, and you need to be ready when it finds you.
Have you ever watched Animal Planet or something and seen one of the shows where you see a bunch of baby turtles or something on the beach? You see the hungry and merciless predator lurking nearby in the shadows waiting for the chance to strike. Now, imagine that egg or that small animal is your retirement nest egg, and the sequence of returns is that predator that's secretly watching you. So now that you understand how important this is, let me explain exactly what it means.
Sequence of returns risk refers to the timing or the sequence of when positive and negative investment returns occur. For the past several decades leading up to retirement, you have been in the accumulation or saving phase, and the main reason why sequence of returns risk, or what I would call SOR for short, is such a significant threat is that most retirement savers go straight from the accumulation phase to that spending or distribution phase, and they completely remit the necessary planning in between. Now that in between is what I call the preservation phase, and as a retiree, it has everything to do with your retirement nest egg’s ability to stand the test of time.

The most important concept to understand is that there comes a point where when, or the sequence in which your money performs, will be just as important as how well your money performs. And that point in time is that distribution or spending phase. Therefore, I want to emphasize that retirees should begin focusing on account balances over time, not just investment performance such as, you know, up X percent or down X percent in any given year or over the last five or ten years, for example.

As you'll notice in the examples I'm gonna give you, in the accumulation phase, that savings phase, there actually is no sequence of returns risk. But in the distribution phase, it can be detrimental to your retirement income. So, let's start by explaining the differences between these phases.
So, in the initial accumulation and savings phase of your life, you will likely have bouts of great investment performance and some periods of poor investment performance.
However, when you experience those ups and downs, doesn't necessarily matter. Here's a simplified and hypothetical example. If you had a $100,000 retirement nest egg and you make no additional deposits anymore, and you have annual returns over a five-year period of positive 40%, positive 20%, 0% return or flat return in year three, negative 15% in year four, and negative 20% in year five, your ending account balance at the end of year five would be roughly $114,000.
If we then were to reverse the order of those returns, the sequence, and we have the steep negative returns starting first in year one with negative 20% right out of the gate, your ending portfolio balance at the end of that same five years would be, you guessed it, $114,000. So, you see, this timing or sequence of when the positive and negative returns occur is called the sequence of returns. And it does not matter in the accumulation phase. The ending balances in each scenario are exactly the same. Said differently, the ride on the way to a sufficient nest egg can be nerve-wracking at times, but it ends up in the same place.
Now let's look at the distribution or spending phase and why it is so different. During the distribution phase, you are ready to crack the nest egg or your inheritance and begin to live off the income that it can provide. Now in today's world, with the lack of guaranteed pensions provided by employers, it's becoming more important for your nest egg to provide you and your spouse sufficient income for a potential 20 or 30-year retirement. Not to mention the ever-increasing cost of goods, aka inflation. Also, the increasing cost of services. Of equal importance is making sure that the nest egg is somewhat accessible or liquid in case you need to tap into it for large unforeseen expenses. But who has those, right? I know I don't!

This distribution phase will also have periods of great investment performance and some poor because you will likely still have the majority of your money invested. However, if the preservation and planning phase or that in between I mentioned is skipped, when you experience the ups and downs, absolutely matters.

Again, here is a simplified hypothetical example I'll use to explain this piggybacking off the last. So, we'll take the same portfolio, $100,000, no additional deposits in, but this time you're in the distribution phase, so you're taking distributions. In this case, we'll use $6,000 a year as an example to be taken from the $100,000 portfolio. If you fully retired and stopped working, then had the same annual returns over the first five years of retirement of positive 40% in year one, positive 20 in year two, flat or zero return in year three, negative 15 in year four, and negative 20% in year five, your ending account balance at the end of year five would be roughly $90,000. If we were to then reverse the order of those returns and we have the steep negative returns starting first in year one with negative 20% out of the gate, your ending account balance at the end of your first five years of retirement would be, drum roll please, roughly $71,000.

As you can tell, in the distribution phase, that is when you begin to live on your hard-earned savings, the sequence of returns absolutely matters, and it matters a lot. What's even more interesting and quite scary in this particular example is that just three years into retirement, your portfolio would have roughly $50,000, so cut in half. So, how would you feel if you ended up in a situation like this and had only half of your portfolio left so soon after retiring? Stressed a little? Yeah, I think so.
Sequence of returns risk further increases investment portfolio risk because humans are emotional, and emotions and investing don't mix. This leads to irrational investment decisions and often leads to a deteriorating retirement investment portfolio, which ultimately causes some retirees to end up outliving their money.
Now, one example of an irrational investment decision would be selling stocks at a low point. That's an easy one. So, something like, you know, in year three, in our example, when your portfolio is cut in half. Not having a plan to get back in the market if you got out and if you did, how will you reinvest if you get back in? And therefore, you're eliminating or clouding the potential for future growth in your portfolio.
Now, before we go over how to help reduce this risk, I want to go over an interesting hypothetical case study using two retirees to help further illustrate my point. So, let's start with retiree number one. Meet Raymond, age 65. Raymond retired in 1969 with a $100,000 nest egg, invested in a 60% stock, 40% bond overall portfolio. Raymond withdrew $8,000 per year for the next 30 years to supplement his retirement income. Now I wanna pause for a second and make a quick aside here. This would be a little high of a withdrawal rate, in my opinion, these days. So, withdrawing $8,000 a year off a $100,000 portfolio. But these numbers I am going to share with you are based upon actual data represented by the annual returns of the S&P 500 for stocks and the 10-year treasury bond, respectively, for the 30-year period, 1969 through 1998, with $8,000 a year annual withdrawals.
Back to the example. By the year 1993, Raymond's nest egg had completely run dry, leaving him five to six years short on income, no money for any unforeseen medical expenses, and nothing to leave to his spouse or heirs should something happen to him. Interestingly enough, however, during the 30-year period from 1969 through 1998, that 60/40 portfolio had an average annual return of around 11.78%. Just a reminder, that's an average return, not a positive 11.78 return each and every year.
So, now let's go over to retiree number two. Meet Diana, age 65. Diana, on the other hand, had retired in 1979 with the same $100,000 nest egg, invested in the exact same 60% stock and 40% bond portfolio. Diana also withdrew $8,000 per year for the next 30 years to supplement her retirement income. And again, these numbers are based on actual data represented by the annual returns of the S&P 500 for stocks and the 10-year treasury bond, respectively, this time for the 30-year period, 1979 through 2008, with $8,000 a year annual withdrawals.
Here's where things get really interesting. In our example, not only did Diana not run outta money during her 30-year retirement but by the end of the year 2008, so 30 years later and during the great recession, Diana had a remaining account balance of roughly $874,000.
So, you're probably wondering how in the world could this be possible. Well, this is because she started her withdrawals, her distribution phase, in 1979 versus 1969 when Raymond started, which was drastically different in terms of the portfolio's performance. Diana's portfolio had several great years of returns right out of the gate as she started to take distributions from her portfolio.

This is when sequence of returns really matters. Raymond's timing was obviously not so lucky. He experienced numerous market downturns shortly after retiring while also taking withdrawals that further hurt his portfolio's return in down market cycles. Now, it doesn't stop there. During the 30-year period from 1979 through 2008, which was Diana's hypothetical retirement, that portfolio that they both had used had an average annual return of 11.2%, nearly the same as the period for Raymond's retirement from 1969 through 1998. In this case study, we see the drastic effects that sequence of returns risk can have on a retiree’s finances and that average annual returns don't tell the whole story.

In fact, Diana had a slightly lower average annual return than Raymond did. The crazy thing about all of this is that although it may seem far-fetched or
counterintuitive, lower returns can still lead to better results. The key here
that I want you to take away from this is that you shouldn't focus entirely on
the returns of your investments in retirement. It's also important not
to simply choose and rely on your investments based on historical returns and costs only. Instead, you should focus more on your account balances over time and strategies to maintain them as much as possible.

Okay, here it is. The moment you've all been waiting for. How can you address this problem? And my answer is what I call the preservation phase. This is the part in between the savings or accumulation phase and the spending and distribution phase of your financial life. As you've learned by now, it's not efficient to jump straight from one to the other. This is because of potentially devastating hazards, like sequence of returns risk, or maybe even something like high taxes or unforeseen expenses.
Now there are, of course, several ways to address those previous issues, and some are far simpler than others. I would say make your strategy as simple as possible, and most importantly, make sure it's something that you can stick to. You know, kind of like a diet. The only diet that works is the one that you can actually stick to. You’ll also wanna make sure that you can track whatever it is you're doing on an ongoing basis and adjust if needed.

So, first things first. You must have a specific purpose in mind for your money. Only then should you formulate a strategy to help you reach your goals. Your strategy should be implemented during this preservation phase. And saying the goal for your money is to grow is not a specific enough purpose. Get more specific. What will the uses or potential uses of your money be, and when will the different amounts be needed?
For example. Is your retirement investment portfolio designed to provide you with retirement income only? Is it supposed to provide you with a retirement income and help you self-fund a potential long-term care need? Do you want to pass a legacy to any of your heirs? You get the point.
At a very high level, one example strategy could be to break down your nest egg into different buckets, boxes, sleeves, whatever you prefer to call them, that each serves a specific investment purpose like the ones I just mentioned. This simple strategy alone can solve most of the issues previously discussed if done correctly and followed prudently.
One remaining issue, however, is figuring out a way to remove your emotions from the investment plan. You could have the best strategy, but if you interfere with it or change it frequently, it's likely not going to work as intended. If you think you'll eventually interfere with your strategy due to drastic market swings, for example, or you would stress out if a large unexpected withdrawal were to temporarily derail your plan, this may be where you start to consider having a financial planner or similar professional take over the implementation and monitoring aspects for you.
Let's look at this type of strategy in action. If you took the $100,000 nest egg in Raymond's scenario in 1969 and broke the account up into buckets, here's what that might look like. He may have three buckets total, for example. The first bucket is a short-term bucket where the purpose of the money here is to be his emergency fund, as well as his first full year of retirement income, which again was $8,000 in our previous example. And let's say he needs a $10,000 emergency fund that leaves him with $18,000 total in. Let's call this his ‘now bucket’ because it's money that he essentially needs right now.

Now, instead of, or in addition to, an emergency fund, this could also be money set aside for a planned expense. Like maybe you need to buy a new vehicle when you retire because you previously used a company vehicle. This is all going to depend on your needs and how these buckets or sleeves are structured. Now because Raymond will absolutely need this money very soon, he shouldn't be risking it. Therefore, it should be allocated to cash and not invested. This would help prevent Raymond from liquidating stocks to generate the cash needed, maybe after they had dropped in value, which would further damage the portfolio, which, remember, they were down in his scenario.
The second bucket could be the money that he needs soon over the next maybe two to five years, for example. Raymond's main goal was to have a retirement income, so the money in this bucket could be earmarked to fund his retirement income in years two through five. Remember, we already have his first year ready to go in his ‘now bucket,’ so, therefore, we can take $8,000 and times that by five to give him $40,000 in his second bucket, for example.

Now, over a two to five-year time period, Raymond can't run the risk of not keeping up with inflation or not having his money work for him at all. So, in this bucket, he may decide to invest the $40,000 in a mixture of lower-risk
investments such as CDs or maybe some short-term bonds, or maybe even some sort of annuity.

The particular mix would depend again on your needs and the dollar amount that you have available. But in either case, this bucket should have some liquidity. In other words, the entire bucket of money should not be inaccessible or cost you anything to access. In Raymond's case, this bucket has the goal of generating returns simply to keep up with inflation and hopefully earn more than his bank account at the very least. Every year, this bucket would refill the needed annual income portion of the cash in the ‘now bucket.’ So, we have one bucket refilling the other on an annual basis. The remaining money left to allocate in Raymond's example would be $42,000, which is his $100,000 minus the already allocated $58,000 between the two buckets.

So, the goal for Raymond's third bucket will be to grow and outpace inflation. It will serve as the well that he can tap, that will refill his ‘soon bucket’ that has two to five years of income in it. This is the money that he will need later. So, if we call it the ‘later bucket,’ Raymond's ‘later bucket’ is just as important as the ‘now bucket.’ This bucket is out of sight, out of mind, at least initially. Again, this bucket has the goal of growing significantly over time and outpacing inflation. And I'm talking about a long period of time, such as like 10 to 30 years for the majority of it. We have basically given the money in this bucket permission to do so by allowing it to stay invested in more growth-oriented investments as long as we don't eventually run up and kick it over.

The types of investments in this bucket, again, need to grow. Therefore, they will likely carry significantly greater risk and volatility compared to the other two buckets in this example. Time compound interest, purpose, and the fact that this bucket is in growth-oriented investments should reduce the threat of Raymond running into sequence of returns risk.

The beauty of this ‘later bucket’ is that Raymond won't have to worry about the inevitable emotional decision-making that comes with a deteriorating account balance. This helps eliminate irrational investment behavior. In addition, this bucket is not subject to the annual withdrawals by Raymond, which helps preserve its growth potential.

Again, he doesn't need to sell investments that may be doing poorly in order to meet his cash needs. He will have a bucket that can not only refill his ‘soon bucket,’ that second bucket during good times in the stock market, but it also gives him the potential to leave his spouse with an income-producing asset, so she isn't left in the dust if he predeceases her.

Now, the ‘later bucket’ can also allow him to increase his income over time due to the effects of inflation and give him access to a lump sum amount for major medical expenses or long-term care later in life if that's a priority for him. Again, this type of high-level strategy is completely customizable to your needs. This type of strategy can be implemented in many ways, and it can incorporate multiple accounts, multiple retirees, or even be used for managing an inheritance.

This type of process sounds rather simple in theory, but I will say from real experience that it does take some significant work once the machine starts working. When the cogs get turning, and you get past that first year of retirement, you now need a system and a process for managing a strategy like that.
The point is that you need to make something that makes sense academically and is something you can actually stick to. Again, like I said before, just like your diet, when it comes to your health. It won't help if you stick to it for three months, then abandon it when something unexpected comes up, and something unexpected will come up. There is much more that can be done depending on your situation. And I want to remind you that any strategy implemented must also play well with the other areas of your financial life. So, for example, your tax situation, your social security situation, Medicare, your legacy planning. Just remember, begin focusing on account balances over time, not just investment performance.

That's it for today's show. If you have a minute and find this information actionable and insightful, and you want to stay up to date on the latest and useful retirement planning content, please subscribe to or follow the show on your favorite podcast app.

If you'd like to learn more about the rules and strategies I discussed in today's show, you can find the links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/eight. And as an early gift this holiday season, in today's show notes, we're also including our newest quick reference guide that includes the important numbers to know for 2023, such as retirement plan contribution limits, IRMA Medicare surcharge brackets, ordinary income tax brackets and capital gains, tax brackets, and much, much more, so you can start planning for the new year.
You can also sign up for the monthly Retired-ish newsletter there as well, where each month, we discuss money and emotions, investing, tax, estate tips, Medicare and Social Security, and even a brief discussion about the current markets in layman's terms. We always include something actionable in our newsletters so that you can implement strategies right away, such as how-to guides and other simplified strategies. Again, this can all be found at retiredishpodcast.com/eight.

Thank you for tuning in and following along. See you next time on Retired-ish.

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