How to Avoid Outliving Your Retirement Savings? It’s All in the Sequence

One of the bigger pitfalls new retirees face is sequence-of-returns risk, which is the risk that losses early in one’s retirement years will jeopardize their savings’ ability to sustain their spending through the end of their years. It’s a concept that’s informed work that my colleagues Amy Arnott, Christine Benz, Tao Guo, and Jason Kephart have done as part of the popular “State of Retirement Income” study they recently authored.

One question readers of the study have asked is when does sequence risk recede? Is there a point at which retirees can exhale because they’re far enough along on their journey to ensure that sequence risk is safely behind them?

Visualizing Sequence Risk

To address that, I asked one of the study’s authors, Tao Guo, to pull data for the scenario that’s most fraught with sequence-of-returns risk: when a retiree invests entirely in stocks. Because stocks are more volatile than bonds, the risks of early-retirement losses are more acute when a retiree invests only in equities.

In the study, Tao and his coauthors found that this all-equity portfolio could support a 3.1% starting spending rate for retirees making fixed real withdrawals each year from an investment portfolio (assuming a 90% probability of having funds remaining at the end of an assumed 30-year retirement period).

Starting Safe Withdrawal Rates, by Asset Allocation and Success Rate

Amy Arnott, Christine Benz, Tao Guo, and Jason Kephart found the starting safe withdrawal rate for a 100% equity portfolio with an assumed 30-year time horizon was 3.1% per year.

We focused on the 10% of simulated random trials in which the retiree exhausted their savings before the end of retirement to see how many of those “failures” involved early-in-retirement investment losses. We found that nearly 70% of these “failures” involved trials in which the retiree’s investments had lost value by the end of year five of retirement.

We also looked at it the opposite way—by ranking trials based on their simulated returns in the first five years of retirement and seeing how the failure rate varied. For instance, we assigned the 20% of trials that had the lowest returns to the “Bottom” quintile and tallied-up the number of trials that failed, and so forth for the other groupings. There was a far higher risk of exhausting retirement savings when returns were poor in the first five years.

When Is the Coast Clear?

That establishes that the first five years of retirement are pivotal to success or failure, but does that mean if you escape the first five years unscathed that you’re in the clear? Not quite. After all, if 70% of the failures involved trials that suffered losses in the first five years, it means that, by definition, the other 30% involved cases where the investments had gained in the earlier years but subsequent spending and investment losses prematurely depleted the retiree’s savings anyway.

So, the question becomes—how likely was it for early retirement gains to give way to later losses, which, coupled with ongoing spending, ran the retirement savings dry? The good news is it’s pretty unlikely: If you made it through the first five years of retirement with investment gains, there was only about a 1 in 25 chance you’d subsequently deplete your savings before reaching the end of retirement, assuming you stuck with the system of fixed real withdrawals. Even after one year of retirement, a gain cut your risk of failure in half.

Did there come a point in retirement when sequence risk was fully in the rearview mirror? It depends on how we define sequence risk. If we define it as failures stemming from losses in the first five years of retirement and focus on trials that avoided losses at any point in those first five years, the risk of failure shrank to about 1% by year 15 of retirement.

That didn’t extinguish risk of failure altogether—losses in subsequent years could prove just as lethal as losses in the first five, after all, depending on their depth and duration—but it was far less common for losses outside of the first five years of retirement to waylay a plan.

Investor Takeaways

It’s clear the initial years of retirement are critical to ensuring retirement savings can go the distance. Our research finds that if a retiree emerges from the first five years of retirement unscathed by losses, it substantially reduces the likelihood that he’ll prematurely exhaust his savings.

Given this, retirees are well advised to diversify their portfolios to mitigate the risk of early-in-retirement losses that can threaten their savings’ ability to sustain spending over an assumed 30-year horizon.

This is evident from the State of Retirement Income study itself, which found that one would wring more income out of a retirement savings fund by diversifying away from stocks and toward fixed income. This is because the bonds acts as a shock absorber, tamping down volatility and the risk of losses in earlier years, facilitating higher spending.

Starting Safe Withdrawal Rates, by Asset Allocation and Success Rate

Amy Arnott, Christine Benz, Tao Guo, and Jason Kephart found the starting safe withdrawal rate for a 100% equity portfolio with an assumed 30-year time horizon was 3.1% per year. However, the starting safe withdrawal rate rose as the retiree diversified the portfolio away from stocks and toward bonds.

While most newer retirees are probably sitting on investment gains right now, given an upward trending market, that obviously won’t hold true forever. In the future, if you’re a newer retiree whose investments have sold off, you could be at a higher risk of exhausting your savings depending on your spending rate. In such a scenario, it can make sense to dial back spending, if only for a time, using one of the flexible withdrawal approaches that the authors explore in the study, while also considering diversifying more broadly into bonds.

Switched On

Here are other things I’m writing, reading, listening to, or watching:

• Amy Arnott on which stocks have destroyed the most shareholder value and Christine Benz on how to wring-out more retirement income than 3.7% after inflation
• Ben Carlson: “There Goes My Hero”
• “Blame Game”: Adam Grossman on how we’ll know when passive investing has gotten too big
• McKinsey & Co. on the looming financial advisor shortage
• Berkshire Hathaway shareholder letter
• Slow Horses
• Karen O and Danger Mouse: “Super Breath”

Don’t Be a Stranger

I love hearing from you. Have some feedback? An angle for an article? Email me at jeffrey.ptak@morningstar.com. If you’re so inclined, you can also follow me on Twitter/X at @syouth1, and I do some odds-and-ends writing on a Substack called Basis Pointing.