The starting year of retirement makes a huge difference in the success or failure of a retirement plan. This is the key difference between the accumulation phase of investing and the withdrawal phase of investing. Yet the majority of investing writing does not take this key difference into account when speaking of returns, asset allocation, planning, etc. So, lets look at how important the starting year of retirement is to a successful outcome and what potential a retiree can do to mitigate this risk.
Why does the starting year of retirement matter in the first place? It is because retirement involves yearly withdrawals from the portfolio. Once you start making yearly withdrawals from a portfolio the sequence of investment returns, the year by year order of those returns influences how much you can withdraw from that portfolio and have it last for the full retirement period. This is NOT the case pre-retirement where there are no yearly portfolio withdrawals. The figure below (from Gestaltu) shows three separate return paths to the same final total portfolio value.
The blue line shows a constant return path. The red line shows an early bull market followed by a weak market and the green line shows an early bear market followed by a strong bull market. For an investor in wealth accumulation mode, all three return paths have the same result – the same end wealth. But that’s not the case for retirees. The blue line retiree enjoys a consistent retirement and in fact their safe withdrawal rate (SWR) can be set equal to the portfolio return. Unfortunately, the blue line return assumption does not exist. It never has. Annual returns are lumpy. There are some good years and some bad years. And it turns out the order of good vs bad years makes all the difference for retirees. In retirement literature this is called sequence of returns risk or path dependence in retirement. The red line retiree in the figure above can enjoy much higher withdrawals from their retirement portfolio than the green line retiree even though the returns over the entire period are exactly the same. Using the blue line return as the SWR, the blue line retiree would have a successful retirement. The red line retiree would have a wildly successful retirement and the green line retiree would run out of money. For a great case study of this particular scenario see here.
If the sequence of returns matter in retirement then how can we measure it’s impact? We can look at the correlation between time period returns and SWRs. As hinted at in the previous paragraph early returns are much more important than later returns. The chart below show this quite clearly. From Michael Kitces who has a great recent post on this topic.
Turns out that 10 year real returns have the highest correlation with SWRs. Also, notice that nominal returns don’t matter nearly as much as do real returns which makes sense since retirement is about keeping inflation adjusted spending consistent. 10 year real returns explain almost 85% of the SWR. This is where the attention should be focused – on the first 10 years of retirement. Now lets look at some specific retirees of the past to give you a feel for the impact of these numbers. See the table below.
In the table I show the 60% stock/40% bond portfolio 10 year and 30 year period return figures for various years of starting retirement. The first two rows show the worst case retirement periods in history, the 30 year periods starting in 1966 and 1929. The 1966 period alone solely determines the historical SWR. See here for more on 1966. As the table shows, the 30 year period returns are pretty darn good even for the 1966 retiree. However, what really hurt the 1966 retiree was the first 10 years of retirement where their returns were negative on a real basis. The 1929 retiree despite the worst stock market decline in history experienced higher real returns than the 1966 retiree (even though nominal returns were lower). As they say, you can only eat inflation adjusted income. Just for kicks, now look at Mr and Mrs 1982. Wow! What a retirement. Simply, really, by luck of the draw of when they retired.
What does the future hold? For the 1999 retiree, the first 10 years have definitely not been great but they have not been as bad as the past. In fact it looks like the 1999 or the 2000 retiree are proceeding to a successful retirement (see here for the latest data). But it was dicey those first 10 years. And what about those who are considering retiring shortly? That is a whole other topic for a post but what needs to be considered is clear. Retirees need to consider what weak returns during the first 10 years of retirement can do to their portfolios and put plans in place accordingly. I’ve touched on this topic in other posts on various portfolio options and spending strategies that can improve the probability of a successful retirement. I’ll return to it again in future posts. There is much to say.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.