Ep #142 - Timing Matters: Understanding Sequence of Return Risk

Here’s a hard fact to digest: You can average 6%-7% returns and still run out of money — because the order of those returns matters and because the timing of when you are withdrawing money matters. But smart planning can help you stay confident and in control, even in volatile markets. Listen in as Adam and Ben discuss cash, flexible withdrawal plans, three bucket theory, and tax aware planning.

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[00:00:00] Adam Werner: Hi everyone, and welcome to AB Conversations, where we will help you CFP your way out of it. A podcast where you get into the minds o f a couple certified financial planners on how we think and feel about everyday financial planning questions, and what should really matter most to you. A healthier financial life starts now.

[00:00:28] Ben: Here we go into podcast time again. Adam, how are you today?

[00:00:33] Adam Werner: I'm doing just great. How are you?

[00:00:34] Ben: The sun is shining. We're embarking on a four day weekend, so.

[00:00:39] Adam Werner: Yeah.

[00:00:39] Ben: Super excited to record a fun podcast with you and then get the heck outta here. Enjoy the weekend. Yeah.

[00:00:46] Adam Werner: Recording it right before 4th of July.

Supposedly, the sun is supposed to be out for like days at a time moving forward, which is a nice.

[00:00:53] Ben: I don't believe that.

[00:00:55] Adam: I did actually.

[00:00:56] Ben: I've heard, yeah, I've heard that before.

[00:00:58] Adam: Yeah. I was gonna say, I'm pretty sure this morning my wife looked at the weather and said, guess what? It's supposed to rain again after, the way home commutes, like, of course it is.

[00:01:06] Ben: Yeah, right. So hard, hard pivot into a topic today. It's gonna be a little investment focus, but of course being who we are, the key here is to focus on the planning around the investment. So here's the cold hard truth. You can average the 6, 7% rate of return. Sometimes we'll put into our planning projections based on how somebody might be allocated, and you could still run outta money.

And there's two reasons for that. Some people would, you know, quickly jump to, yes, what I'm withdrawing matters. But the sequence of you, you returning the positive 6, 7%, you know that's an average. If there are some negative years when you're withdrawing money and then positive years, the sequence in which you have those returns is actually a really big risk to the portfolio.

So let's just talk about the smart planning around that to hopefully help people stay confident that volatile markets don't need to completely derail their plan.

[00:02:04] Adam Werner: Yeah. Yeah. So maybe just diving in a little bit deeper on what does that really mean? Yeah. I guess I'll just, I'll give an example, right?

We'll start there. I think most people understand that if, I'll say in this scenario, not taking withdrawals, just the plain math on, if I had a million dollars, I lost 10% in a year, now I'm at 900,000. For me to get back to a million that following year, I need to earn more than that 10% that I lost.

'Cause if I only earn 10%, now I'm at 990. I'm short of my million dollars. Right? So when you lose, you need to gain a little bit more to get back to your original number. But that gets compounded by withdrawal. So to your point, that's where this sequence of when those good years or when maybe those bad years are happening.

While you're taking withdrawals can really have a big impact. So I'll lay out a similar example. Start with a million dollars market is down 10%, or you lose 10% in that given calendar year. Now you're at 900,000, but you're also taking a 5% withdrawal on your million dollars. So now you also took out 50,000.

The end of the year, you're down to 850. Now next year, what do I have to earn to hopefully maybe get back to my original million dollars? Well, it's not just I need to make up the 150,000 now that I took out and lost, but I'm gonna take out another 50,000, if that's what I need in retirement. So now I'm basically at 800,000.

I really need to earn like 20, 25% that following year to hopefully get me back to what was, you know, ground zero step, step one of, you know, baseline. So, that's where some potentially negative years early can really have long-term impacts.

[00:03:56] Ben: Yeah. And of course that's a snapshot in time of like two years.

Right. But I, I really like the point that you're making because that is going to compound over longer periods of time. Like, so we could use a different example. If two different investors earned the same amount of like the same percentage of returns over consecutive years, like 15%, 5%, 0%, -5 and -15.

Right. Put that all together. You went nowhere. If you were on the wrong side of this and year one was your -15 and year five was your positive 15, you ended up on a, on your million dollar example, you end up somewhere around like 680, 690,000. If you flip that and you had your positive years first, and it's the same sequence of returns and -15 was your last year.

You're up at like 760. Right? So there's almost like a 10% difference there when you had the same rates of return. So what we're really trying to illustrate here is we can talk about long-term averages, but really it's the timing of your withdrawals that can become an issue. And that's what we wanna talk about today.

What can we do to kind of negate that in some ways?

[00:05:08] Adam Werner: Yeah. It's, I think it's just it speaks to just the danger of using long-term averages for the reality of retirement for many people. Yeah.

[00:05:17] Ben: Real, real world timelines.

[00:05:20] Adam Werner: Yeah. We don't live in that vacuum where if we could get six or 7% a year with regularity, that makes the planning process super easy.

It becomes just an equation, right? We just need to solve it. But yeah, the reality of the situation is it just, life does not work that way. Markets do not behave rationally at all times. So that's where, again, we just have to, what are those ways to mitigate it.

[00:05:42] Ben: I think there's actually, like, if we can stay here real quickly, there's actually people that are maybe more vulnerable to this.

[00:05:48] Adam: Sure.

[00:05:49] Ben: Like, we'll just start with what we were identifying. If you maybe need to take larger withdrawals early in retirement, and that's when those, I guess, tough markets are happening and you aren't positioned for that.

Right? That's clearly somebody that's gonna be a little bit more vulnerable to that.

[00:06:04] Adam Werner: Yeah. Yeah. Another example would be if in a scenario, and I think it really does come back to that withdrawal rate being one of the bigger driving factors, right? But someone that may just retire a little bit earlier, and therefore has a longer time in retirement, you're just exposing yourself to more opportunity for that sequence of return to kind of move your retirement success around.

[00:06:29] Ben: I'd also thrown to that camp people we meet some people that have done an awesome job. I would say just being investors, like set it, forget it. Investors that lean heavily into equity and stock exposure, 'cause they're like, yeah, hey, I know growth is gonna happen over time. Like behaviorally, they have the right profile.

But then yeah, you know, they come to us ready to retire and they've got a hundred percent in equity. Right? They, of course then, if they're gonna need to rely on that portfolio are gonna be. Vulnerable to the whims of, well, what's the market gonna do in that first year of retirement? Is it a bad year for stocks? Is a good year?

[00:07:05] Adam Werner: Yeah. That level of volatility can be heightened with a more concentrated portfolio or just, yeah, a more stock heavy or maybe not as quite diversified portfolio that should help smooth out some of those fluctuations over time. So, how do we actually help strategize around that?

Like how do we start to insulate ourselves or our clients from some of that risk? Number one is just having an appropriate buffer in terms of cash flow, right? Savings. And this goes into kind of the, our three bucket theory, right? Bucket one being, Hey ha, have cash, have one to two years worth of expenses in either cash or very short term bonds so that if you're in a scenario where those first, the first year or two of your retirement while you're taking withdrawals, the market is not in good shape. You're pulling from cash and hopefully allowing your investments to recoup any losses that have occurred.

And why one to two years? Because the typical pullback lasts anywhere from that one to two years, 18 months. Even what we've seen more recently is that timeline has greatly shrunken for pullbacks. I mean, we'll just use this year, right? Different scenarios every time it happens. But you look at what happened from basically February to April and the market was down almost 20% from its peak.

[00:08:32] Ben: Yeah.

[00:08:32] Adam Werner: And here we are, not even three full months later, and the market has not only eclipsed that, that loss, but now we're hitting all time highs yet again. So that one to two years worth of cash hopefully allows a lot of people to just buy time, to not have to touch their investments that are fluctuating with the market.

[00:08:52] Ben: Yeah. And replenish that cash. So I'm thinking logistically, okay. How do we as planners help. One example is, again, we felt pretty good about the market, where it was at the end of last year, and whether you call this a rebalance or not, and we can talk about, you know, two different examples here. People that we know were in this withdrawal phase, right?

The people we're talking about potentially being vulnerable or needing being forced to take distributions that required minimum distributions. We, in December just might have said, Hey. Let's take some of our gains off the table. We had a good year and let's put that into cash. And that's going to buy us the time that if the market does have, as it did right, we're not gonna get this right every time.

But as it did, had a bad, first quarter, we didn't have to be generating cash during a very volatile time. Right? It's the same reason using the example of a hundred percent equity investor that's ready to retire. Hey, now's a really good time to maybe rebalance your account, take some of that stock off the table, some of those gains and put it into cash knowing that you might, we think you're gonna spend it next year.

[00:09:53] Adam Werner: Yeah, and I think for a lot of people and the, I think it, it kind of runs the gamut and people fall on different ends of this spectrum. For some people they the idea of like that opportunity loss. Yeah. Like, I'm gonna build cash, just feels, doesn't feel good. Right? But if the market is still gaining, then I should have just left it all in.

But that's not, in our mind, that's not the purpose. It is really, that maybe just speaks to who we are. We're thinking of, or planners. How could this go awry? And oftentimes it is just, which one would feel worse? Is it giving up maybe some opportunity? Or if in a scenario where the market is down and now you're needing to take withdrawals more often than not, I think that feels worse to most people, but it is still something to navigate, right?

That, that idea of, but I'm building cash, but it's not doing anything. It is doing something for your plan, but maybe not earning as much as you may want it to, but that's not necessarily his primary purpose at that point.

[00:10:51] Ben: Yeah, and let's not even put ourselves in that spot is what we would say as planners, like statistically, we know psychologically that feeling of pain from making the bad call usually is much bigger than the euphoria from, Hey I, I eeked out a little bit more gain. So yeah, cash, that's number one.

[00:11:10] Adam Werner: Yeah.

[00:11:11] Ben: I'll give a second example in planning, I think, just like, we wouldn't want to just say, here are your average returns.

We want to be cognizant of like what your withdrawal strategy really could be year to year, and wanting to recognize that could be a little bit more dynamic. There is a different, difference between filling your needs versus your wants or the wishlist. So if we approach some of your withdrawal strategy being kinda like the guard rails, a approach, if the portfolio is up.

Okay here's what we're gonna take out, and it might be increasing spending in those years. If it's down, then, you know, maybe we lean back and temporarily cut on some of those wishlist things. So in the example you were using earlier, if it's the math of taking $50,000 a year, maybe we're flexing between 40 and 60, right?

Just to hopefully sustain the portfolio in times when things aren't going well.

[00:12:05] Adam Werner: Yeah. I feel like we may have shared this in other versions of the podcast too, where we have a client or maybe several clients at this point that kind of have gotten used to while they were working and earning right, getting a bonus.

And that for many people when there is a bonus like that is mentally accounted for separately than, you know, my typical income that covers my normal expenses that can help fill that wishlist. So in the scenario where there are gains. We want to make sure that we are taking those gains and passing them forward.

Right. Going back to what you had said earlier, making sure that we are replenishing that cash buffer from the things when they are doing well. When the market is hitting all time highs, that's usually a decent time to carve off some of those gains. Yeah. And help replenish that cash component. Because ultimately, I know we've described this in different versions talking about the three bucket theory that should really work like a conveyor belt, right? Yeah. You have your gains in your long-term growth and you just continue to pass those forward to your middle bucket. Then your middle bucket fills your cash bucket, and hopefully you can get that where more often than not, it's essentially, in an ideal world, that's a self-sustaining kind of process.

Doesn't always work that way, but still going through that exercise to make sure that you are taking those gains when they're there and not just letting things ride forever. Because we know people are going, more often than not, people are going to spend, and we need to make sure that's in a safe and protected spot when they need it.

[00:13:34] Ben: Yeah. And what came to mind there, Adam? As you're talking about that we are really just trying to eliminate the timing of all of this and that's how big institutions do it. Like how do big endowments do it when they, that, that is their income source. Like it's these portfolios, they'll take like rolling three year returns or rolling five year returns, and that's how they develop their withdrawal strategy to like fill their budgets. Right? These institutions can't just stop spending 'cause there's one bad year in the market. Right? Right. So, so they're trying to average out the look of their returns for their spending.

[00:14:08] Adam Werner: Yeah. So another way, and this doesn't work for everybody but it's a very simplified way of looking at it.

Just living off of the income that your portfolio is producing, right? You're not, hopefully not touching principle in that scenario. Then theoretically it's irrelevant what the values are at any given point in time, as long as it's generating the income that you need or want in retirement.

Definitely strategy. Yeah. You're just living off the interest and in theory, that pretty much eliminates that sequence of return risk because you're only living off of what it's producing. Without worrying about the fluctuation.

[00:14:45] Ben: Yeah. And I'd say that's, it's more common for us to see or recommend that be combined with that idea of also taking gains when you have it.

Like there is a role in rebalancing. But yeah, that's a good one too. So I think the last planning topic that we'd really talk about is really being, I guess, tax aware in your withdrawal strategy, right? Trying to limit the bite of taxes. And that just comes back to there's not only this three bucket theory on how we separate our investments between cash and fixed income and equities.

But there's different tax buckets too. There's the taxable bucket, we'll call that like non-retirement, in this brief conversation. There's the IRA bucket, right? Where you're gonna continue to pay income taxes on retirement accounts. But then there's a tax free bucket. So, I don't know, maybe we can go back and forth here.

There definitely is a part of our process that would say your withdrawal strategy should also be combined with a tax aware withdrawal strategy?

[00:15:45] Adam Werner: Yeah, for sure. And it's gonna be different for every situation, but more often than not, for people that are, maybe on the earlier side of retirement, that typically lends itself to hopefully building that non-retirement bucket because that is the least, or maybe I'll frame it a different way, that is the most tax efficient way without leaning on your retirement account to get access to some savings in a minimally impactful tax side of things.

[00:16:20] Ben: Yeah, so I think like, let's play out a scenario because we do have some of these clients, and I would hope people listening to this podcast like, think about diversifying where they save too. If you're in that camp where you retire early and you're able to then rely on those taxable accounts, right?

You're not paying ordinary income tax on that money that gives you so many other options, right? Because a lot of retirement planning should be trying to think about what do I do in my lower tax years, which hopefully come right after you retire, right? You leave peak earnings, now you're controlling your income tax bracket.

If I'm living off of my savings, that taxable bucket. We're big fans of converting IRA funds to Roth IRA funds during low income years. Right? And if you do that, not only is that keeping you in a lower tax bracket. By combining that with a Roth IRA conversion, you're helping reduce income taxes that might spike later, because you have to take required minimum distributions.

[00:17:21] Adam Werner: Yeah. Well and it's that domino effect then at that point. And we certainly have seen this in practice. For people that may have done a great job of saving into that pre-tax retirement account. It can become its own animal, right? And once you hit that RMD age, it's kind of hard to navigate that.

You lost a lot of that flexibility at that point. And then it, again, it has that compounding effect of, okay, now if my RMD is gonna push me into a new tax bracket, that could also lead to paying more on your capital gains in a non-retirement account. It could put you in that situation where now you're paying more for your Medicare because it's pushing you into that, that higher income bracket, like it's, this, again, nothing with planning, nothing usually happens in a vacuum. There are often a lot of these little dominoes that happen along the way as well.

[00:18:11] Ben: Right? That might help you defer your social security, right? If you have access to that bucket. All of course, this all requires you actually proactively saving into that type of environment.

But maybe I should have started here. It's just to realize that if, going back to our example, if client says, or we determine through planning you need to take out $50,000 a year. Well, if that's coming from a retirement account, we're not taking out 50,000. We have to take out what, 60,000 withholding 10 for taxes.

Like, it's more than that. So as you kind of are creating wealth, if you're able to have these different buckets, you really are then controlling the net of what you truly need to withdraw.

[00:18:52] Adam Werner: Yeah. And in, in an ideal world, that's where we can try to strategize where we're taking a little bit from column A and a little bit from column B, and maybe we look at column C to try to maximize the efficiency when it comes to not only just the taxes, but then that can trickle over to the investment implications as well.

[00:19:13] Ben: So I've got one more thing that I would say, and I realize I'm gonna reiterate some things we've said recently. But it's really important for your withdrawal strategy to just be proactive in thinking about what lifestyle shifts might be occurring in your life, right?

If that's changing a living situation, needing care, you know, wanting to help others. The reality is we certainly have clients and we can try to be very proactive in planning. But when you have to now make a quick decision on something in life, it is often the case that you are just limiting your choices.

And if now you need to take care of something during a downtime when you weren't really, weren't prepared for it, again, that's going to be where this sequence of return risk is really gonna slap you.

[00:19:55] Adam Werner: Yeah. Yeah. So maybe to kind of summarize. Maybe the main point or the kind of the main takeaway, market timing isn't necessarily the main issue, but the timing of withdrawals and maybe the quantity of withdrawals are kind of the deciding factor.

Again they work in concert. Sometimes it works okay. And we've seen this right the last few years have been generally very good for market returns. And I think for people that may have started with a higher withdrawal rate early in retirement have been slightly insulated from those potential negative impacts because the market has carried a lot of that weight, but it could very quickly go the opposite direction.

Hence the whole theme of this podcast, right? The timing of those returns really do matter, but just making that point that it's not necessarily just the timing of the market returns, but it's the timing of your withdrawals and the degree in which you're taking those withdrawals as well.

[00:20:57] Ben: Yeah, so do you have enough cash set aside?

Is that withdrawal strategy that you have somewhat flexible, right? And do you have money in three buckets to kind of support that? And then are you coordinating those withdrawals with your overall tax picture too? You know, if you're not sure, that's why you reach out. We'll talk through it.

[00:21:16] Adam: That's it? Yep.

[00:21:18] Ben: All right, pal. Enjoy your holiday weekend.

[00:21:20] Adam: You do the same.

[00:21:22] Ben: Catch you next time.

[00:21:23] Adam: Thanks.

[00:21:30] Ben: Hey everyone, Adam and I really appreciate you tuning in. Please note that the opinions we voiced in the show are for general information only, and are not intended to provide specific recommendations for any individual. To determine which strategies or investments may be most appropriate for you, consult with your attorney, your accountant, and financial advisor, or tax advisor prior to making any decisions or investing. Thanks for listening