Sequence of Returns Risk (SoRR)

Those about to start withdrawing what will be a lifetime of income from their investments are subject to one of the greatest risks in retirement income planning. The risk is called sequence of returns risk, or SoRR.

Imagine two individuals who both retire on the same day, withdraw the same annual amount, and earn the exact same average rate of return until they die.

• Retiree A gets -20% in year one and -5% in year two.
• Retiree B gets +20% in year one and +5% in year two.

Even with the same average rate of the return until death, Retiree A might run out a money well before Retiree B. Or Retiree B ends up with a much larger estate.

There’s a ton of content about SoRR online. This video is one the best.

The most important thing to consider, though, is that SoRR is a concern for the first few years of retirement; not your entire retirement. A bad market in year one is far more damaging than a bad market in year four or five or ten.

SoRR declines over time. The further you get into the retirement, the less impact it can have. This is, of course, because of the power of compound growth.

What can you do to avoid this risk? There are many schools of thought.

• Reduce portfolio volatility by adding more cash and bonds.
• Create a ‘cash wedge’ or a ‘bucket’ to draw income from in bad years.
• Choose a lower starting withdrawal rate, like 3.2% instead of the common 4%.

My problem with the first two options is that they are the same thing. You’re giving up long-term return potential to avoid short-term volatility. Equities are volatile, but they have far better potential returns than cash and bonds, especially after inflation. Would you rather draw from an investment that historically has earned 7% a year, or 4% a year? My job is to get you through the volatile times, and I will.

My problem with the third option is that you’re hamstrung by the value of your portfolio on your retirement date, and you’re stuck with that value throughout retirement.

Here’s what I prefer. First, set aside an emergency fund that is not part of your retirement nest egg. Second, use a dynamic withdrawal strategy.

The appropriate value of that emergency fund is subjective and should be dependent on your comfort with volatility. I suggest anywhere from two to five years of your known income needs. I will always try to have clients set aside just two years, because five years leaves a lot of potential returns on the table. I have to respect clients’ tolerance for volatility, though. If they want a five-year emergency fund, so be it.

If the first few years of retirement coincide with a bad market environment, draw from the emergency fund and not your investments.

But here’s the important consideration, and it’s a consideration I’ve only recently accepted: once you’ve exhausted the emergency fund, don’t fill it back up. It exists to protect you early in retirement.

The dynamic withdrawal strategy I believe in is called the Guyton’s-Klinger Guardrail approach. This Guardrail approach is a dynamic withdrawal strategy that adjusts your retirement income based on market performance within preplanned – you guessed it – guardrails.

Here’s how it works (example below):

• Start with a reasonable withdrawal rate. I use 5%.
• Set a guardrail range, like your portfolio increasing by 25% or decreasing by 20%.
• If your portfolio rises enough that your percentage withdrawal rate drops below a certain percentage, say 4%, you give yourself a raise. if your portfolio drops enough that your withdrawal rate exceeds a certain percentage, say 6%, you take a pay cut.

With numbers now:

• A retiree withdraws $50,000 per year on a $1,000,000 investment portfolio (5%).
• If, counting their withdrawals and market performance, their investments fall to $800,000, that same $50,000 withdrawal becomes 6.25% of their portfolio ($50,000 divided by $800,000). That exceeds the -20% portfolio guardrail. Next year, to be safe, the withdrawal amount must drop. If/when markets recover, the income can rise again.
• How much must the withdrawal amount decrease by? Either by 10%, $50,000 down to $45,000, or just reset back to 5% of the current investment value.

That’s the worst case. I had to call many clients after the 2022 bear market to let them know the amount of their withdrawals needed to decrease. January and February of 2023 weren’t fun.

On the other hand, after the bull markets of 2023 and 2024, clients were thrilled to have their withdrawal amounts reset higher.

This approach adjusts withdrawals in a disciplined way and extends portfolio longevity in ugly market conditions.

I prefer this method because it reduces the risk of running out of money before you’re dead, and you have control. I also prefer this method because it ensure you don’t end up on your deathbed wishing you spent more money in retirement.

I believe one of the most important components of a retirement income plan is knowing what to do in bad times. The emergency fund and the guardrail approach provide us with instruction for what exactly to do in bad times, regardless of our emotions.