In Part 1 we explained what the 4% rule is, how to apply it and where it came from. However, betting all your money on a “rule” is pretty risky, even if it is based on academic research. I understand why not everyone will be comfortable relying on that “rule” for several decades ahead. One way to make a good and informed decision is to be aware of the risks. That’s why I want to introduce to you one of the biggest risks of your (and my) retirement plan. The risk is called the “sequence of returns risk”.

What’s the sequence of returns risk?

The sequence of returns risk means, in the simplest way, that the bad years come before the good years. Don’t worry, I’ll explain why it matters.

Imagine you have 3 years in which the market yields -30%, 10%, 50%, not necessarily in that order.

If you start with £100,000 and don’t withdraw anything, it doesn’t matter which year comes first. The reason is, as we were taught in maths lessons in school, the order doesn’t matter when multiplying. You will always get:
£100,000* 70% * 110% * 150% =£115,500.

“So if the order doesn’t matter, what are you on about?”

The logic above only applies when we have no withdrawals. However, we already discussed in part 1 of this series that we can withdraw 4% a year adjusted to inflation. Let’s look at 2 examples.

Example 1: Good years come first

In this example, we will assume the order is 50%, 10%, -30%. We withdraw 4% and annual inflation is 2%. That means that the withdrawal for year 1 will be £4,000, year 2 will be £4,080 (£4,000 * 102%) and year 3 will be £4,161.60 (£4,080 * 102%).

Year 1Year 2Year 3
Starting amount£100,000£146,000£156,520
Yield (£ and %)£50,000 (50%)£14,600 (10%)– £46,956 (-30%)
Withdrawal– £4,000– £4,080– £4,161.60
Closing amount£146,000£156,520£105,402.40

In this example, we ended with £105,402.40, not amazing but not bad. We’re 3 years into our retirement and still have more money than we started with (before adjusting to inflation of course).

Example 2: Bad years come first

In this example, we assume the same inflation (and therefore withdrawals) as in example 1. However, we will now reverse the order and have the bad years first. We will assume the market returns -30%, 10%, and 50% in that order.

Year 1Year 2Year 3
Starting amount£100,000£66,000£68,520
Yield (£ and %)£-30,000 (-30%)£6,600 (10%)£34,260 ( 50%)
Withdrawal– £4,000– £4,080– £4,161.60
Closing amount£66,000£68,520£98,618.40

In this example, we only end up with £98,618.40, less then we started with and that’s before even adjusting for inflation.

What’s the difference?

OK, in example 1 we had the good year first and in example 2 we had the bad year first. The reason is the % of the portfolio we withdraw. The 4% rule said we can withdraw 4% of our INITIAL portfolio (the value of our portfolio when we retire). However, let’s look at how much of our new value we withdraw each year.

Example 1:

Year 1- 4,000/150,000= 2.67%
Year 2- 4,080/160,600= 2.54%
Year 3- 4,161.60/109,564= 3.80%

Example 2:

Year 1- 4,000/70,000= 5.7%
Year 2- 4,080/72,600= 5.62%
Year 3- 4,161.60/102,780= 4.05%

As you can see, the fact that the bad year came first changed everything. In example 1, by the time the bad year came it only decreased it to £109,564. That meant that the 3rd year withdrawal was only 3.80%. That’s what a bad sequence of returns can do to your portfolio.

In example 2, not only did the market crash our portfolio to a value of 70,000, we took 5.7% out of that. That’s a 35.7% hit to our portfolio, a hit it couldn’t recover from.

Also notice that in example 1, the bad year (-30%) wiped off (year 3) almost £47k and in example 2 it “only” wiped off (year 1) £30k. That doesn’t matter, all that matters is the sequence of returns, which is the order in which different returns (yield) occur.

Now imagine a few bad years in a row, like 2000-2002 where the S&P 500 returned -9.10%, -11.89%, and -22.10% in that order. Then, a few years later one hit bigger than 30%, like in 2008, where the S&P500 returned -37%!
You can see the data in the table in this link (Yahoo Finance).

In 2015, Michael Kitces (more about him later) looked at that exact question. He posted his results in this post.
His conclusion is that a retiree that retired in 2000 or 2008 is not worse off than a retiree in any other bear market (where the market goes down) in the periods used in the Trinity study. His conclusion is that it actually shows how conservative (yet not bulletproof) the 4% rule is.

What does a bear market mean for you?

Should you U-turn from retirement and go back to work after a 1-year bear market? Luckily, the answer is “no”.

The first reason is that the original research done by Bengen and the Trinity researchers (which we discussed in part 1 of this series) included bear markets in their research. The periods they looked at included both bull markets (where the market goes up) and bear markets. That means that they arrived at 4% as a safe withdrawal rate AFTER taking bear markets into consideration.

The second reason comes from the research done by Michael Kitces, an American researcher and blogger.

Kitces looked at the correlation between:
1) The first year’s market returns; and
2) The highest safe withdrawal rate the portfolio could have survived with over a 30-year period if it started on that year.

Important note: in his research he uses a 60/40 portfolio (60% equity, which is stocks/shares and 40% bonds).

Kitces noticed there was actually a very low correlation between the two. He even noticed that a retiree that retired in the worst year (-42%) would have still been OK with a 5.34% withdrawal rate.

“Does that mean the 4% is bulletproof?”

Of course not, it just means that the first year is not a good enough indicator (a correlation of 0.21). He noticed that a 10-year annualised return has a higher correlation (0.44) with the safe withdrawal rate. He also noticed that if you increase the period further, the correlation does not increase. A decade seems to be the “sweet spot” for looking at market returns and safe withdrawal rates.

What does a real bear market mean for you?

No, when I say “real” I don’t mean the opposite of fake. I mean the opposite of nominal. In economics, real amounts mean inflation-adjusted amounts.

Despite a bear market sounding scary*, the really scary scenario is a combination of a bear market and high inflation which will decrease your portfolio AND increase your withdrawals, double hit!

Not a real bear. Sequence of returns
Not a real bear

When Kitces looked at 10-year real returns and safe withdrawal rate, he got a correlation of 0.79, which means it’s a very good predictor. He writes: ” just as a bad first decade can be so severe with ongoing withdrawals that a subsequent market rebound just isn’t enough to recover, but a good first decade can be so positive that even a subsequent bear market can’t ruin the outcome!”.

I highly recommend you read Kitces’ full post on his research, you can find it here. I found the graphs in the post especially informative.

How can I apply the sequence of returns to my retirement plan?

Kitces’ research results about the sequence of returns mean that one (or a few) bad year(s) shouldn’t worry you too much. However, a bad decade should activate your internal alarm. After 10 years, you can re-evaluate your situation and maybe adjust your plan if you experienced a really bad decade.

In the next part of the 4% series, we will look at flexible withdrawals. The Trinity study assumed a retiree keeps the same lifestyle (same amount each year, adjusted to inflation). Will you really keep your expenses the same if your portfolio is cut by half? That’s the question we’ll try to answer next time.

Until then, have a great weekend!

*”Bear market” doesn’t really sounds scary, it actually sounds adorable. I want to take my daughter to a bear market, sounds like a fun day out.