Working longer avoids sequence of returns riskThe term “sequence of returns risk” refers to the risk that your retirement nest egg may not last if you get a bad patch of returns at the start of retirement.

That reality doesn’t really have anything to do with this blog’s usual subjects: tax laws, accounting, and small business.

But in a recent post about why entrepreneurs often ought to consider working longer, I commented that working longer lets someone avoid sequence of returns risk. Some people challenged that a bit. And asked some questions.

So I wanted to elaborate. But let’s start at the beginning.

An Example of Sequence of Returns Risk

Many people know that history suggests you can usually draw four percent from your nest egg and then adjust the withdrawal amount annually for inflation.

Someone who starts retirement with $1,000,000 can draw $40,000 the first year.

In the second and all subsequent years, they can bump up the previous year’s draw amount for inflation.

If inflation runs five percent in year one, in year two the person can draw $42,000. Because $42,000 is five percent more than $40,000.

Almost always, that four percent draw rate works. In fact, only five cohorts of retirees would have failed when using a four-percent draw for a thirty-year retirement since roughly when the U.S. Civil War ended. People starting in 1965, 1966, 1967, 1968 and 1969.

And those five failing cohorts? They fail because of a bad patch of returns (and inflation) as the person’s retirement starts.

Avoiding Sequence of Returns Risk

No one can know ahead of time whether they start retirement at the wrong time. Sequence of returns risk will be apparent only when you or I look in the rearview mirror.

But this maybe useful observation: Work a few years longer? Maybe three or four or five years longer… so you move the start of retirement farther into the future?

Well, do that and you inoculate your retirement portfolio against sequence of returns risk.

Fact-checking the Math

You can check my math on this. And should. Here’s how.

Visit the cFIREsim retirement planner and click Run Simulation button. cFIREsim will calculate roughly 120 retirement planning scenarios where someone with a $1,000,000 plans to retire for three decades starting immediately and where the person plans on a $40,000 draw to start.

Five scenarios, or roughly four percent, fail. All because of a bad sequence of ugly returns and terrible inflation in the late 1960s and through the 1970s.

Then, add five years to the retirement start date and click the Run Simulation button again. cFIREsim will again calculate roughly 120 scenarios for someone with a $1,000,000 who plans to draw $40,000 to start and annally adjust for inflation. But with a tweak. This time, the person calculates scenarios where retirement starts in five years, not today, and then runs for twenty-five years.

When you run this second “work longer” scenario? No historical scenarios fail (at least using cFIREsim’s default asset allocation of 75 percent stocks and 25 percent bonds.) Because the person dodges the sequence of returns risk.

Why Working Longer Works

And why does working longer work? A couple of reasons basically.

First, when retirement portfolios fail because of a bad sequence of returns at the start, failure occurs at the tail end of the retirement. Shortening the length of retirement in effect cuts off the tail where failures potentially occur. That’s the first big reason working longer works.

A second thing that helps when you work longer? The extra compounding of investment returns on a larger portfolio. That compounding nicely bumps up the size of a retirement nest egg. Working five more years, for example, on average bumps the starting retirement nest egg size by maybe 30 to 40 percent percent? And then a related point: If you or I work longer, we can probably add a bit more to the nest egg.

Note: Using the cFIREsim default portfolio settings and delaying retirement for just three years zeroes out one’s sequence of returns risk. Historically, then, you don’t actually need to work five years longer. Just three. And that’s assuming you don’t add to your retirement nest egg.

Final Comments

A couple-three final comments to wrap up this short essay.

First, most people don’t retire with a $1,000,000. Or anything near that amount. I used $1,000,000 here because it makes the math easy. And because that’s the number cFIREsim uses as its default.

Second, if you have a job you hate? This plan doesn’t work. You know that. I know that. This idea to work longer is a plan for people who like work and all it entails. Or maybe an idea for people who like work most days.

A final third point: This idea of working longer isn’t the only way dial down your sequence of returns risk. Other tricks and techniques exist. For more information, check out our series on developing a “Plan B for retirement.”


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