Sequence of Returns Risk is overstated.

If you spend any time at all in the retirement planning blogosphere you’ll get an earful about Sequence of Returns Risk.

I’ve gradually come to believe that the way this is commonly discussed is misleading to the point of being wrong. I wrote about it once before…

…but that post focused on Maximum Safe Withdrawal Rates (MSWR); I wanted to revisit it but with a different perspective.

One of the common complaints about MSWR-type analyses is that they aren’t very reflective of what an actual person would experience. You only know the MSWR when you are dead — hard to go back in time and tell yourself you should have used a higher or lower number — and they assume constant inflation-adjusted withdrawals which isn’t what people actually do.

In the following I’m going to do two things that are a little different from normal retirement analyses:

  1. Instead of constant-dollar withdrawals we’ll use one of the many better & more realistic withdrawal strategies. In this case I’ll use a method first proposed by Bob Clyatt in his book Work Less, Live More. It is a straightforward method:
    Calculate 5% of the current portfolio.
    Calculate 95% of whatever you took out last year.
    Use the bigger number.
    This means that if your portfolio drops suddenly (like in a big market crash) then you will gradually reduce withdrawals instead of making a massive cut.
  2. Instead of looking at inflation-adjusted withdrawals, we’ll look at nominal withdrawals. This reflects what people see “in real time”. In the real world people rarely do inflation-adjustments to compare their portfolios or withdrawals across time.

That was a lot of words. Let’s look at some pictures.

Retiring around the Great Depression 1927–1931

These charts show what an actual retiree would have received for various years around the Great Depression. This is one of the worst sequence of returns possible but you probably wouldn’t have drawn that conclusion from looking at the above charts. They don’t exactly scream “a retirement of misery and hardship”.

The worst of them is (unsurprisingly) the 1929 chart, so let’s look at that in a bit more detail.

Yes, after 14 years your withdrawals have gradually been whittled down to $30,000. (Remember you mentally went into this whole retirement thinking “4% rule means I’ll be getting $40,000 for life”.) That’s a reduction but

  1. It wasn’t a “new normal” of permanently low withdrawals. Yes, it was preceded by years of belt tightening. But that occurred gradually and gave the retiree plenty of time to make adjustments to their lifestyle.
  2. It isn’t that far off from the mental benchmark of $40,000. As long as your retirement included some wants and not just needs this is likely more akin to “no vacations this year” than serious hardship.

To be clear, I’m not saying this retirement wasn’t affected by returns. Obviously they had to cut spending. That was due to the Great Depression and we’re probably not surprised that when unemployment was over 20% a retiree didn’t escape entirely unscathed.

But “sequence of returns risk” doesn’t look like quite the monster we had been led to believe.

To drive the point home, let’s look at the other “worst time to retire” scenario — the late 1960s.

In all of these it is hard to see what the actual problem is. Withdrawals stay essentially flat for the first 15 years (which is when the recessions happened) and then climbs substantially once the boom years of the 1980s hit.

We’re hard pressed to see any effect of sequence of returns risk here, even though this is a period where portfolios fail in some analyses.

We can also check two recent large crashes, 2000 and 2007, and look for evidence of sequence of returns risk adversely affecting retirees:

So what’s going on here? Why do we see limited evidence of sequence of returns hurting retirees? Especially when everyone else in the retirement blogosphere talks about sequence of returns risk as the single biggest thing to be afraid of?

So far we’ve exclusively talked about nominal withdrawals. Most retirement research uses inflation-adjusted withdrawals. Here’s an example of how big of a difference that can make:

Here’s a 1966 retirement looking at nominal withdrawals.

Doesn’t look so bad, right? We started out at $50,000 a year and the worst we ever saw was $44,560 a year. Nothing really to write home about.

But if we take those same withdrawals and adjust them for inflation they look like…

Ouch. That’s pretty brutal. The inflation-adjusted value of our withdrawals has been cut by two-thirds! Our previously rosy picture is looking decidedly less great now.

But is the real culprit here sequence of returns? Or is it inflation?

And that’s really the point I want to make: when retirement researchers use “real returns” they are mixing up two things:

  1. Equity returns
  2. Inflation

But when people talk about “sequence of return risk” the mental image they have is a big crash in nominal stock prices. When we look at the correlations between inflation and equity returns they don’t have much correlation.

From Asset Management by Andrew Ang

They aren’t strongly correlated (or anti-correlated), so lumping them together as “real returns” obscures the fact that there are two relatively uncorrelated things moving at the same time.

To make matters worse, the correlations change over time.

From Asset Management by Andrew Ang

The relationship also appears to vary between countries

Bekaert and Wang find that inflation betas of equities are generally negative for all developed markets, with an average of -0.25. Even when they are positive in certain developed countries, the inflation betas are low and far from one. For example, the North American inflation beta is -0.42 and the EU inflation beta is 0.27.

All of which is just to give more support to the idea that we need to be mindful when combining “equity returns + inflation” into a single “real returns” number and then drawing conclusions from it.

I think a more accurate statement would be:

Sequence of equity returns can put a damper on retirement but inflation is what would wreck it.

But I reckon most investors, especially these days, spend a lot more time worrying about a stock crash than about inflation.

Learn how to enjoy early retirement in Vietnam. With charts and graphs.