When planning for retirement, most people use some basic assumptions to determine how much they need to save each month in order to retire at the age they desire. The phrase "assuming a 7% real rate of return" may be considered redundant in the office of a financial advisor.
But basing your retirement planning on a steady 7% rate of return is fundamentally flawed. Everyone knows investing in the stock market doesn't return 7% year in and year out. Sometimes the market crashes. Sometimes it soars. And sometimes it doesn't really do much of anything.
Image source: Getty Images.
The sequence of returns you get during your investment career will have a massive effect on how much wealth you've accumulated by your retirement age, or how long you'll have to work in order to retire comfortably. On the flip side, sequence of return will also affect how quickly you spend down your retirement savings. A poor sequence of returns could require a significant reduction in retirement spending to ensure you don't run out of money.
You'll rarely ever get what you expect
Over the 40 years from the summer of 1942 to 1982, the S&P 500 index produced a real compound annual return of 6.43%. In the 40 years from the summer of 1961 to the summer of 2001, it returned an average of 6.44% per year.
Here's what happened if someone invested $300 every month in an S&P 500 index fund (let's pretend that was possible) over those two periods versus what you'd expect with steady returns.
Image source: Author, based on data from Robert Shiller.
As you can see, the two investing periods achieved very different results despite the same average market return and the same amount invested.
Furthermore, neither was anywhere close to the expected return from a steady growth rate. The person who started investing in 1942 ended up with 40% less than expected, and the person starting in 1961 ended up with 50% more than expected. That's quite a margin of error when it comes to planning for the rest of your life.
Granted, these two periods are some of the more extreme examples, but they're certainly not the most extreme 40-year stretches. They're just two periods with comparable returns but very dissimilar sequences to achieve that return. There's potential for much higher long-term returns and much lower long-term returns as well.
Here's what happened
Almost everything comes down to the last 10 years.
In the early part of your career, monthly retirement contributions generate a significant portion of the increase in your account balance. Even if the market returns 50% in your second year investing, your monthly contributions will outweigh the investment returns. But by the time you've consistently invested for 30 years, the market returns are doing pretty much all of the work to grow your wealth.
It's the opposite when you're in retirement. While it's the last ten years of a working career that can make or break a retirement goal, it's the first ten years during retirement that matter most. Again, this is because you'll potentially have more money working for you in the market before you make significant withdrawals from your retirement savings.
Unfortunately, there's no way to predict the sequence of returns you'll get in your investment journey. Market prognosticators can be pretty good at diagnosing long-term expected returns from the stock market, but if anyone says "The market will go up next month," they're just gambling. So, the best way to ensure a healthy amount of money to retire on is to do your best to mitigate the sequence of return risk.
How to mitigate sequence of return risk
There are several strategies someone can take to mitigate the risk of a poor sequence of returns:
- Start investing early. The earlier you start, the more likely you are to have a good chunk of money invested when a good sequence of returns shows up. This is why it usually doesn't make sense to try to pay off a mortgage before investing.
- Don't withdraw funds early. The corollary of the above strategy is to stay invested as long as possible. Don't raid your retirement account for things you want today like a bigger house or a new car. You want as much money as possible working for you late in your career.
- Make room in your budget to spend less. This is different from simply saying "Spend less." This is giving yourself the option to spend less. If you can spend less in months when the market declines and invest the excess in your budget, you'll have more invested when the market eventually hits that good sequence of returns. If you can spend less some months in retirement, you'll be able to survive a bad year of returns.
- Manage your asset allocation appropriately. Shift more assets into bonds as you near retirement. Bonds are less volatile than stocks but also come with lower expected returns. That means your downside is lower, but the upside is lower too. The trade off for lower expected returns is that you'll need to save more per month than if you're just planning to get that 7% inflation-adjusted return for your entire working career. The other option is to work longer than originally planned.
Interestingly, most financial advisors also recommend you continue shifting your asset allocation toward more bonds as you move through retirement. This can be a mistake, however, as once you move past the first few years of retirement without significantly depleting your savings, the odds of financial ruin decrease dramatically. It would make more sense to decrease your bond allocation as you move through the early years of retirement.
Understanding sequence of return risk and how it could affect your investments will allow you to fortify your retirement plans to make sure you end up where you want to be financially.
