Whether you’re planning for a traditional retirement at age 60+, or working towards an early retirement goal, thoughts of “will my money run out?” will no doubt have crossed your mind.
There is a lot written about safe withdrawal rates. This refers to the rate you can afford to draw down on your savings, so that there’s no risk of your savings being depleted during your life time. The most common rule of thumb guide here is 4%, and that’s certainly a useful starting point. The answer for you though will depend on how you invest your savings, and also at what age you retire. So for instance if you retire at 75, you could probably draw at 8% per year and face no real prospect of your money running out before you do. Whereas someone hoping to retire at 45 would need to be much more conservative with the draw down rate.
Similarly, if your preference is to invest very conservatively, mostly in cash and term deposits for instance, then your safe drawdown rate might need to be 2% for instance.
But today’s post isn’t about safe draw down rates. Instead, when thinking about the “will my money run out” question, a key determinant is a concept called Sequencing Risk. It’s a jargon sounding term I know, but understand this, and manage for it, and the chances of your money running out in retirement will be dramatically reduced.
In my role as a financial planner, clients often want me to find them the best return each year. But actually a far more important role for me to play is to manage their asset allocation so as to minimise the chance that their money runs out during their lifetime.
A key way we do this is to plan for sequencing risk. So what is sequencing risk? Well, it refers to the importance of the order in which your returns occur – the sequence.
So let’s say you typically invest in a Growth type asset allocation – so you’ve a good weighting towards shares and property, but still keep something like 20% of your savings in cash and bonds to smooth out volatility a little.
With this asset allocation it might be reasonable to assume the average return over 30 years will be 8% per year. Armed with this assumed return, you can then project forward what your savings will grow to, and when thinking about how much you can afford to draw down each year in retirement, you could work back and say for instance “well if I earn 8% and draw 5% each year, that leaves 3% to combat inflation – I’ll be sweet”.
The problem with this is that in almost no individual year will you actually earn 8%. Year 1 the return could be 11%, 2%, or even -6%. Year 2 the same and so forth.
So the average return number may well be correct, but that doesn’t mean that in the first 3 years of your retirement you don’t earn 1% or 12%. And it turns out, those returns in the early years matter a lot!
A good quote from commentator Michael Kitces sums the issue up well, “It’s not enough for returns to average out in the long run, if the portfolio could be completely depleted before the good returns finally show up.”
Another way to think of this is that an asset can only be sold once. If you are forced to sell a share at $10 because you needed the cash, the fact that 2 years down the track it rises to $20 is not at all helpful.
Interestingly, further analysis by Kitces found that a sharp drop, followed by a fairly rapid recovery, was actually less damaging than a protracted period of below average returns.
It’s worth highlighting here too that overspending in those early years is essentially the same as having a protracted period of below average returns. It dramatically increases the chances that your money will run out.
So what’s the plan?
Want to minimise the chance that your money will run out in your retirement? Here’s what you should do:
- Use conservative assumptions when running projections. So if you’ve structured your portfolio so it should average an 8% return over the long run, perhaps run your projections assuming 6%. If you build in a bit of fat here, then if returns are poor early, it only eats into that fat, and doesn’t torpedo your entire plans.
- Reduce the level of risk in your portfolio in the 2-3 years leading up to retirement, and keep that risk fairly low for the first 3-5 years of retirement. So this might mean, instead of being invested 80% in shares and property and 20% in cash and bonds, you drop that down to 50/50 3 years out from retirement. And leave it that way for at least the first 3 years of retirement. In this way your savings will be less exposed to any large drops in investment markets, reducing the likelihood of a negative or even just poor return.Now of course there’s a cost here in that a 50/50 asset allocation will on average earn less than an 80/20 allocation. So this gets back to my earlier observation that sometimes, trying to get the highest return every year should not be priority number 1. The objective is to generate income for you for the rest of your life. Whilst maximising returns is important, an understanding of sequencing risk will enable you to recognise that in fact it’s not the most important consideration in the years immediately before and after you retire.
- Have at least your first years drawing requirements, and ideally more, in cash, so that if investment markets drop, you are not forced to sell at depressed prices.This is something I discuss with clients a lot. The price of an asset, be that a share or property (and perhaps even bonds), matters when you buy it, and matters when you sell it. But in between those two points, the price is at best mildly interesting.So in managing for sequencing risk, what we’re trying to do is avoid having to sell assets when prices are down. That’s why, in developing your plans to minimise the risk of your money running out, you need to have at least your first years drawings, and ideally your first several years, sitting in cash or similar (for example a term deposit). Then, if you are unlucky enough to have share prices say, fall in the first year of your retirement, it’s okay, because you didn’t need to sell any shares then anyhow.
Well I hope you’ve found that useful in answering the question most of us have contemplated at some point – “Will my money run out?”.
In the Toolkit for this episode I’ve created a quick cheat sheet of those 3 strategy solutions to help you manage sequencing risk, so be sure to click below to download your copy.
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