2016 started out in painful fashion for all investors, but especially for recent retirees dependent on their investment accounts for living expenses. It highlights an issue retirement researchers call “sequence of returns” (SOR) risk. In this article, we’ll explain what that risk is and look at three ways to reduce it.

What’s the danger?

One of the most commonly recommended rules of thumb for retirement planning is the “4% safe withdrawal rate.” For many years, it has been assumed that retirees could withdraw 4% of their retirement portfolio each year — even adding a cost-of-living increase each year — and have confidence their portfolio would survive their expected lifetime.

Using Vanguard’s Nest Egg Calculator, you can estimate the likelihood that your portfolio will last using various asset-allocation and withdrawal-rate assumptions. For example, the tool says a portfolio with a starting balance of $1 million, an asset allocation of 60% stocks, 30% bonds, and 10% cash, and an annual 4% withdrawal rate has a 92% probability of surviving 30 years.

While such calculators are helpful in the retirement-planning process, there can be a big difference between the simulated world and the real world. In the real world, what matters greatly is the actual sequence of returns you experience. If you face a bear market immediately upon retiring, that can wreak havoc on your finances in the year of the downturn, and for many years to come, even calling into question whether your portfolio will last throughout your retirement.

Wade Pfau, Professor of Retirement Income at The American College, estimates that the returns in the first decade of retirement explain about 80% of a portfolio’s survival for 30 years.

Protective measures

Here are three steps you can take to help ensure your portfolio will last throughout your retirement.

  1. Base your withdrawal rate on your end-of-year balance.
    When people talk about withdrawal rates, they’re often referring to a percentage of the starting balance of the retirement portfolio — the amount you have at the beginning of your retirement. If you have $1 million in your portfolio and use a 4% withdrawal rate, in your first year of retirement you can withdraw $40,000. If you factor in an inflation rate of 2%, in year two you can withdraw $40,800, and so on. This is described as a fixed-dollar amount withdrawal strategy.

    One way to make your planning more conservative is to use a variable-dollar amount strategy in which you base your withdrawal amounts on a percentage of your remaining balance — the balance at the end of each year.

    This will lower the amount you can withdraw in down years, and the amount will change each year. That means you’ll have to be more careful in managing spending. However, this approach boosts the probability that your portfolio will last as long as you need it to. In fact, one planner found that it “eliminates the possibility of ruin” that’s “inherent” in a fixed-dollar amount withdrawal strategy. It may also increase the amount you’ll be able to leave to heirs.
  2. Keep three to five years’ worth of expenses in cash.
    This “retirement cash account” would contain only the portion of your expenses you need to pay from your self-managed retirement portfolio. Many retirees, of course, have multiple sources of income — such as Social Security, perhaps a defined-benefit pension, and possibly some paid work. If you need $75,000 to live on in retirement, and you’re looking to your self-managed retirement portfolio to cover $30,000 of that, you would keep $90,000 to $150,000 in cash.

    With such a cash account in place, retirees would not need to sell any of their stock holdings during a market downturn or subsequent birth of a new bull market (when prices are still relatively low), thereby building in significant SOR risk protection.

    Let’s see how this might work in practice. Consider a retired couple whose budget requires them to supplement their Social Security and pension income by making monthly withdrawals from their retirement portfolio, which they are managing with SMI’s Dynamic Asset Allocation strategy.

    As the 2003-2007 bull market unfolded, our couple could have gradually begun building their retirement cash account by selling their DAA shares during a rising market. By the end of 2006, a strong year in the market, it’s reasonable to think they might have done enough selling that their cash account was “full.” That posture would have caused them to sacrifice some return in 2007, but it would have had them well-prepared when the bear market began the next year.

    As the market began to tumble in 2008, this couple would have stopped making monthly withdrawals from their DAA account, relying instead on their cash account to cover living expenses. Even as the market recovered in 2009 and 2010, they could have continued to live on money from their cash account, allowing their investment portfolio more time to benefit from the market rebound.

    Our retirees might have started to sell some of their portfolio holdings in 2011 as their cash account was finally depleted, using gains from the market’s rise in 2009 and 2010 to replenish their savings to its maximum level.

    An important point here is the timing doesn’t have to be precise for this idea to still work. Even beginning to sell investments as early as 2010 or 2011 in order to begin refilling the cash account still would have provided a benefit.

    This approach allows a retiree to sell into market strength and sit tight during weakness because his or her immediate living expenses are provided in the cash account. Of course, this idea works only if the total portfolio is large enough that having three years (or more) of living expenses in cash doesn’t impose too much of a drag on the portfolio’s total return.
  3. Delay retirement.
    Waiting until age 70 to retire boosts monthly Social Security benefits substantially, provides more time to build retirement accounts, and shortens the amount of time those accounts will have to provide income to cover your costs. It may not be possible to work until age 70, for health or other reasons, but if doing so is an option for you, it can certainly help financially.

Retirement planning, as with investing in general, has much to do with risk tolerance. But at a time of life when even those most comfortable with risk should be scaling back, these steps will help ensure your retirement portfolio lasts throughout retirement.