In our last blog post, we introduced the term "sequence of returns". Now we will run numbers to illustrate its importance.
Let's take a look at three hypothetical scenarios. In each one we'll use the following five assumptions:
Scenario #1 – 7% Return Each Year.
Scenario description: flat 7% return year after year. While this scenario never occurs in real life, it's often used for illustration purposes.
The results: even after taking out withdrawals that begin at $25,000 and more than double to $52,000 at age 90, your portfolio value increases from $500,000 at age 65 to $576,000 at age 78 and then gradually declines in value to $462,000 at age 90. You've taken distributions totaling $964,000 and your portfolio has earned $926,000 over 25 years.
Scenario #2 – Good Early Years
Scenario description: you are fortunate enough to retire at the beginning of a bull market where your investment returns exceed your inflation-adjusted withdrawal rate of 5% for several years, you experience a couple of years of negative rates of return, and a bear market kicks in your final three years, resulting in negative rates of return each year.
The results: although it doesn't occur in a straight line, your portfolio increases from $500,000 at age 65 to a peak of almost $1.5 million at age 87, with a final value of $921,000, or double the value of Scenario #1, at age 90. Like Scenario #1, you've taken distributions totaling $964,000 and your portfolio has earned $1.385 million over 25 years.
Scenario #3 – Bad Early Years
Scenario description: we simply reverse the order of investment rates of return that we assumed in Scenario #2. As in Scenario #1 and Scenario #2, over 25 years, we're going to end up with the same average rate of return of 7%.
The results: the first three years are going to be bumpy, as your portfolio value increases by $208,000 the first five years, going from $500,000 at age 65 to $708,000 at age 70, it decreases by $224,000, going from $500,000 at age 65 to $276,000 at age 70, or a swing of $432,000 during the same period. Your portfolio continues to decrease in value each year until it is depleted at age 81. Instead of taking distributions totaling $964,000 as you did in Scenarios #1 and #2, your total distributions over 25 years are only $541,000. Furthermore, instead of realizing portfolio income totaling $926,000 in Scenario #1 and $1.385 million in Scenario #2 over 25 years, your total portfolio income is a measly $41,000!
Is there anyway to protect your portfolio from the bad sequence of returns? The answer is yes, we will discuss in next blog post.
Let's take a look at three hypothetical scenarios. In each one we'll use the following five assumptions:
- Retirement age: 65
- Portfolio value: $500,000
- Annual withdrawals: $25,000, or 5% of the initial portfolio value, increasing by 3% each year
- Life expectancy: 25 years, or until age 90
- Average rate of return: 7%
Scenario #1 – 7% Return Each Year.
Scenario description: flat 7% return year after year. While this scenario never occurs in real life, it's often used for illustration purposes.
The results: even after taking out withdrawals that begin at $25,000 and more than double to $52,000 at age 90, your portfolio value increases from $500,000 at age 65 to $576,000 at age 78 and then gradually declines in value to $462,000 at age 90. You've taken distributions totaling $964,000 and your portfolio has earned $926,000 over 25 years.
Scenario #2 – Good Early Years
Scenario description: you are fortunate enough to retire at the beginning of a bull market where your investment returns exceed your inflation-adjusted withdrawal rate of 5% for several years, you experience a couple of years of negative rates of return, and a bear market kicks in your final three years, resulting in negative rates of return each year.
The results: although it doesn't occur in a straight line, your portfolio increases from $500,000 at age 65 to a peak of almost $1.5 million at age 87, with a final value of $921,000, or double the value of Scenario #1, at age 90. Like Scenario #1, you've taken distributions totaling $964,000 and your portfolio has earned $1.385 million over 25 years.
Scenario #3 – Bad Early Years
Scenario description: we simply reverse the order of investment rates of return that we assumed in Scenario #2. As in Scenario #1 and Scenario #2, over 25 years, we're going to end up with the same average rate of return of 7%.
The results: the first three years are going to be bumpy, as your portfolio value increases by $208,000 the first five years, going from $500,000 at age 65 to $708,000 at age 70, it decreases by $224,000, going from $500,000 at age 65 to $276,000 at age 70, or a swing of $432,000 during the same period. Your portfolio continues to decrease in value each year until it is depleted at age 81. Instead of taking distributions totaling $964,000 as you did in Scenarios #1 and #2, your total distributions over 25 years are only $541,000. Furthermore, instead of realizing portfolio income totaling $926,000 in Scenario #1 and $1.385 million in Scenario #2 over 25 years, your total portfolio income is a measly $41,000!
Is there anyway to protect your portfolio from the bad sequence of returns? The answer is yes, we will discuss in next blog post.
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