The concept of financial independence/retire early (FIRE) is all the rage in the personal finance space. The idea is to save a large percentage of your income (50% or more), live as frugally as possible, and retire in a short period of time while continuing to live frugally.  

Related: How much do you need to save for early retirement?

Sometimes, fortunate young people with higher incomes can do this and retire in their 30’s, and in some cases, their late 20’s!

In any case, the biggest concern with retiring early is running out of money.  The earlier the retirement, the longer a portfolio has to last.

You may read a lot of early retirement blogs that claim that the 4% rule is all you need.  That is, save enough for 25x your annual expenses and you are set for life!  While this may work, it doesn’t come without its risks.

What is the 4% Rule

Let’s rewind a little and get into the background of the 4% rule.  As mentioned, some people assume that a 4% withdrawal from your retirement is super safe for the rest of your retirement life.  However, the devil is in the details.

The 4% rule is the percentage of your portfolio that you can withdraw / year while keeping the balance intact. This is assuming that you stay invested in the market with balanced asset allocation. 

According to William Bengen, CFP, 4% of your portfolio can be withdrawn from your portfolio (increasing with inflation annually) while keeping your portfolio intact for 30 years with high certainty.  This is assuming a 50/50 equities/bond asset mix during retirement.

The rub is that “high certainty” does not mean 100%.  According to this Vanguard Monte Carlo Simulator, a mix of 50% stocks/50% bonds and 4% withdrawal rate results in a 92% probability of the portfolio lasting 30 years. 

Increase the timeline to 50 years, like with early retirement, and the probability drops to 78%.  Would you be comfortable knowing that your portfolio has a 78% chance of survival?

With all the talk about 6% long-term returns, wouldn’t a 4% withdrawal rate last forever?  That’s where the risk of the sequence of returns kicks in.  Perhaps the biggest risk to retirees, especially early retirees.

Sequence of Returns

As you know, the stock market has varying returns every year.  Over the long-term, the returns go up, but it usually moves in a jigsaw pattern while on its way.  The varying annual returns are called the sequence of returns.  

The pattern of the sequence of returns doesn’t matter as much during the accumulation phase because new money/savings is entering the account.  In fact, adding to investments when markets are down is a surefire way to boost your long term returns.

However, the sequence of returns matters during the decumulation/retirement phase because money is coming out of the portfolio without new deposits.  This is especially harmful if a bear market occurs at the beginning of retirement and regular withdrawals are needed to pay for fixed expenses.

Examples

The best way to show the risk of the sequence of returns is through some examples of how it works and how it can impact your portfolio.

Assumptions:

  • $1M portfolio (100% equities);
  • 4% withdrawals, increasing with inflation (assume 2%)
  • Withdrawals are made at the end of the year 

Straight 6% return

With a straight 6% return every year, a 4% withdrawal, increasing every year with inflation is no problem.  Starting with a $1M portfolio, even after withdrawals, the portfolio has grown to $1.8M.  Sign me up!

Year Return Withdrawal Balance Actual Withdrawal Rate
1 6.00% $40,000.00 $1,020,000.00 3.92%
2 6.00% $40,800.00 $1,040,400.00 3.92%
3 6.00% $41,616.00 $1,061,208.00 3.92%
4 6.00% $42,448.32 $1,082,432.16 3.92%
5 6.00% $43,297.29 $1,104,080.80 3.92%
6 6.00% $44,163.23 $1,126,162.42 3.92%
7 6.00% $45,046.50 $1,148,685.67 3.92%
8 6.00% $45,947.43 $1,171,659.38 3.92%
9 6.00% $46,866.38 $1,195,092.57 3.92%
10 6.00% $47,803.70 $1,218,994.42 3.92%
11 6.00% $48,759.78 $1,243,374.31 3.92%
12 6.00% $49,734.97 $1,268,241.79 3.92%
13 6.00% $50,729.67 $1,293,606.63 3.92%
14 6.00% $51,744.27 $1,319,478.76 3.92%
15 6.00% $52,779.15 $1,345,868.34 3.92%
16 6.00% $53,834.73 $1,372,785.71 3.92%
17 6.00% $54,911.43 $1,400,241.42 3.92%
18 6.00% $56,009.66 $1,428,246.25 3.92%
19 6.00% $57,129.85 $1,456,811.17 3.92%
20 6.00% $58,272.45 $1,485,947.40 3.92%
21 6.00% $59,437.90 $1,515,666.34 3.92%
22 6.00% $60,626.65 $1,545,979.67 3.92%
23 6.00% $61,839.19 $1,576,899.26 3.92%
24 6.00% $63,075.97 $1,608,437.25 3.92%
25 6.00% $64,337.49 $1,640,605.99 3.92%
26 6.00% $65,624.24 $1,673,418.11 3.92%
27 6.00% $66,936.72 $1,706,886.48 3.92%
28 6.00% $68,275.46 $1,741,024.21 3.92%
29 6.00% $69,640.97 $1,775,844.69 3.92%
30 6.00% $71,033.79 $1,811,361.58 3.92%

If only real life were so straight forward!  Unfortunately, the market is highly variable and a large drop at the beginning of retirement can be damaging. 

35% market drop followed by a constant 6% return

Let’s take a look at another example with a large 35% drop (like in 2008) at the beginning of retirement and a constant return after. 

In the table below, notice that a $1M equity portfolio would have dropped to $650,000, then another $40,000 withdrawn to fund retirement.  Even with a healthy 6% return that follows annually, it’s not enough to recover from the damage.  This portfolio would have run out of money by year 25.

Fortunately, large market drops have historically been followed by big market gains which help the portfolio recover. 

Year Return Withdrawal Balance Actual Withdrawal Rate
1 -35.00% $40,000.00 $610,000.00 6.56%
2 6.00% $40,800.00 $605,800.00 6.73%
3 6.00% $41,616.00 $600,532.00 6.93%
4 6.00% $42,448.32 $594,115.60 7.14%
5 6.00% $43,297.29 $586,465.25 7.38%
6 6.00% $44,163.23 $577,489.93 7.65%
7 6.00% $45,046.50 $567,092.83 7.94%
8 6.00% $45,947.43 $555,170.97 8.28%
9 6.00% $46,866.38 $541,614.86 8.65%
10 6.00% $47,803.70 $526,308.05 9.08%
11 6.00% $48,759.78 $509,126.75 9.58%
12 6.00% $49,734.97 $489,939.39 10.15%
13 6.00% $50,729.67 $468,606.08 10.83%
14 6.00% $51,744.27 $444,978.18 11.63%
15 6.00% $52,779.15 $418,897.72 12.60%
16 6.00% $53,834.73 $390,196.85 13.80%
17 6.00% $54,911.43 $358,697.23 15.31%
18 6.00% $56,009.66 $324,209.41 17.28%
19 6.00% $57,129.85 $286,532.12 19.94%
20 6.00% $58,272.45 $245,451.60 23.74%
21 6.00% $59,437.90 $200,740.80 29.61%
22 6.00% $60,626.65 $152,158.59 39.84%
23 6.00% $61,839.19 $99,448.92 62.18%
24 6.00% $63,075.97 $42,339.89 148.98%

6% return and 35% market drop at year 15

The main idea is that big market drops at the beginning of retirement are the most damaging.  This is a third example showing a big market drop at year 15 but constant return otherwise.  

Although the portfolio survives until year 30, it taps out at year 39.

Year Return Withdrawal Balance Actual Withdrawal Rate
1 6.00% $40,000.00 $1,020,000.00 3.92%
2 6.00% $40,800.00 $1,040,400.00 3.92%
3 6.00% $41,616.00 $1,061,208.00 3.92%
4 6.00% $42,448.32 $1,082,432.16 3.92%
5 6.00% $43,297.29 $1,104,080.80 3.92%
6 6.00% $44,163.23 $1,126,162.42 3.92%
7 6.00% $45,046.50 $1,148,685.67 3.92%
8 6.00% $45,947.43 $1,171,659.38 3.92%
9 6.00% $46,866.38 $1,195,092.57 3.92%
10 6.00% $47,803.70 $1,218,994.42 3.92%
11 6.00% $48,759.78 $1,243,374.31 3.92%
12 6.00% $49,734.97 $1,268,241.79 3.92%
13 6.00% $50,729.67 $1,293,606.63 3.92%
14 6.00% $51,744.27 $1,319,478.76 3.92%
15 -35.00% $52,779.15 $804,882.05 6.56%
16 6.00% $53,834.73 $799,340.23 6.73%
17 6.00% $54,911.43 $792,389.22 6.93%
18 6.00% $56,009.66 $783,922.92 7.14%
19 6.00% $57,129.85 $773,828.44 7.38%
20 6.00% $58,272.45 $761,985.70 7.65%
21 6.00% $59,437.90 $748,266.95 7.94%
22 6.00% $60,626.65 $732,536.31 8.28%
23 6.00% $61,839.19 $714,649.30 8.65%
24 6.00% $63,075.97 $694,452.29 9.08%
25 6.00% $64,337.49 $671,781.94 9.58%
26 6.00% $65,624.24 $646,464.61 10.15%
27 6.00% $66,936.72 $618,315.77 10.83%
28 6.00% $68,275.46 $587,139.25 11.63%
29 6.00% $69,640.97 $552,726.64 12.60%
30 6.00% $71,033.79 $514,856.45 13.80%

Using Real Returns

Instead of using hypethetical returns, what if we used historical returns instead?  I used a series of historical returns in sequence, and it appeared that most 30 year periods were safe from ruin. Best bet would be to run the Vanguard Monte Carlo simulation above that randomizes historical returns.  

But what if we picked a tough market period like starting retirement in year 2000?  What would the portfolio look like in 2018?  Looking at the table below, it looks like the portfolio survived the dot com crash and 2008 financial crisis.  As you can see, following big down years came big up years as well. As you can see, the market has been very kind since 2009.

What happens after year 19 remains to be seen.  With a hot streak of winning years (except 2018), a correction is long overdue.

Year Return Withdrawal Balance
1 -7.64% $40,000.00 $883,600.00
2 -10.54% $40,800.00 $749,668.56
3 -20.87% $41,616.00 $551,596.73
4 28.88% $42,448.32 $668,449.55
5 11.49% $43,297.29 $701,957.11
6 5.50% $44,163.23 $696,401.52
7 16.12% $45,046.50 $763,614.95
8 6.03% $45,947.43 $763,713.51
9 -35.99% $46,866.38 $441,986.64
10 25.95% $47,803.70 $508,878.47
11 15.28% $48,759.78 $537,875.32
12 2.50% $49,734.97 $501,587.24
13 15.91% $50,729.67 $530,660.09
14 32.10% $51,744.27 $649,257.72
15 13.89% $52,779.15 $686,660.46
16 1.77% $53,834.73 $644,979.62
17 12.04% $54,911.43 $667,723.74
18 21.92% $56,009.66 $758,079.13
19 -3.74% $57,129.85 $672,597.12

Solutions

While sequence of returns risk is real, the bright side is that probabilities are on your side.  As you know, historical returns do not equate to future returns.  It’s possible that we endure a prolonged multi-year bear market without significant recovery years that could be disastrous to a new retiree

Being the conservative investor that I am, I like to reduce risk as much as possible.  Having said that, here are some ways to reduce the sequence of returns risk.

  1. Proper Asset Allocation – Although my examples above use 100% equities, it is not recommended to hold 100% equities during retirement. Volatility pre-retirement is more of a gut-check, but having large swings in portfolio value during retirement withdrawals can result in sustainablilty issues.  You want a balance of enough growth combined with less volatility.  From the Vanguard calculator mentioned above, the sweet spot is between 50% and 70% equities.  You can read more about asset allocation here.
  2. Variable Withdrawals – Consider withdrawing a maximum of 4% of your portfolio balance at the end of the year instead of a fixed amount.  For example, instead of withdrawing $40k every year from a $1M portfolio, go with the flow of the market.  So if your portfolio value drops to $900k one year, withdraw 4% of $900k instead ($36k instead of $40k).  Basically, during negative return years, consider withdrawing less from your portfolio.  This would mean variable withdrawals but would result in a sustainable portfolio over the long term.
  3. Buy an Annuity – If steady payments are a requirement, consider using a portion of your retirement funds to buy an annuity. In exchange for your capital, the annuity will give you steady cash flow for life.  Also, don’t forget to count CPP and OAS into your calculations which are basically annuities that start in your 60’s.
  4. Save Cash before Retirement – Another strategy that resonates with me is to save up to 2x annual retirement expenses prior to retirement.  Use the cash for everyday spending, but use variable annual withdrawals (like in #2 above) from your portfolio to top up your cash on an annual basis.  The 2x cash acts as a buffer against major market downturns.
  5. Spend Distributions Only – My strategy for early retirement is to spend the distributions (dividends) but maintain the capital.  In other words, spend the golden eggs, but take care of the goose!  Here are 4 other reasons why I like dividend investing. However, the downside is that you’ll need a larger portfolio.  As of this post, we have surpassed $50k in dividend income!
  6. Get a Side Gig – For early retirees, one way to stay engaged and to take some pressure off the portfolio is to get a part-time job or business.  For FIRE bloggers, most will continue running their business which may end up making more than enough to pay for already low annual expenses.

Final Thoughts

There you have it, an explanation of the sequence of returns and how it’s one of the biggest retirement portfolio risks.  The biggest concern is if there is a large market correction just after retiring without a large recovery in subsequent years.

Historically speaking, however, large corrections were followed by larger recoveries.  So as long as you can ride it out without aborting the investment strategy (ie. selling everything at a low), then it should all work out with perhaps a nest egg for the next generation.

Build your free cash flow, keep your investing costs low, and let your wealth compound.  Your wealthy and early retiree future self will thank you for it.



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