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The New Rules of Retirement: Part III

| April 05, 2018
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Haven't read Parts I & II yet? This article will make a lot more sense if you read those first - you can find them here and here.

WHY DOES THE SEQUENCE OF RETURNS MATTER?
There is a serious risk to any retirement income strategy. I’m sure it would surprise most people to learn that if two people retired at the same age, with the same amount of money, averaged the same 8% rate of return on that money, and withdrew the same exact amount per year, that one could reach his 90s with more than he started, while the other retiree would become bankrupt in his mid 80s.

The sequence of returns may have less of an impact on the portfolio of a long-term investor who is no longer putting money in, nor taking money out. However, the relationship between an investor’s rate of withdrawal and the sequence of returns can have a dramatic impact on a portfolio’s ability to last during the withdrawal period (usually during retirement).

SEQUENCE OF RETURNS BEFORE RETIREMENT
The following example shows how the sequence of returns works in the Accumulation Phase. In this example, the ONLY difference between Portfolio A and Portfolio B is the sequence of the annual returns in each portfolio. Both portfolios have starting values of $100,000 (one time lump sum), and both average the same 8% overall annual return, the series is just inverted.

Annual Income Withdrawals: None

Starting Values (one time lump sum):
Portfolio A = $100,000      Portfolio B = $100,000

Average Annual Return:
Portfolio A = 8%                Portfolio B = 8%

Value at Age 65:
Portfolio A = $684,848      Portfolio B = $684,848

The above example is for illustrative purposes only and not meant to represent the performance
of any particular investment. Past performance does not guarantee future results.

Notice how NO contributions or annual income withdrawals are made in either portfolio in this example, and the result is an identical total of $684,848 at the age of 65, even though the annual returns were inverted. Once again, this demonstrates that during the pre-retirement Accumulation Phase, the order of returns does not matter.

SEQUENCE OF RETURNS AFTER RETIREMENT
In the Distribution Phase, it's important to note that averaging an 8% return doesn’t mean steadily receiving 8% per year of interest and earnings every year. There are some good and some bad years of investment returns. 

Now let’s look at that same returns data, but only this time in the post-retirement or Distribution Phase. In the following example, again, the ONLY difference between Portfolio A and Portfolio B is the sequence of the annual returns in each portfolio. The annual returns are exactly the same for the two retirees, the sequence of returns is just inverted. However, since this is post-retirement, each retiree is now taking a withdrawal each year. The withdrawals will be the same, beginning at 5% of the starting portfolio value of $684,848 and increased each year for inflation.

Annual Income Withdrawals: 5% of first year value (adjusted thereafter for inflation)

Starting Values (one time lump sum):
Portfolio A = $684,848      Portfolio B = $684,848

Average Annual Return:
Portfolio A = 8%                Portfolio B = 8%

Value at Age 65:
Portfolio A = $0                 Portfolio B = $2,622,984

With each portfolio having the exact same factors except just the sequence of returns inverted, retiree A is broke at age 82! Withdrawing in a down market and having multiple bad years at the beginning caused the failure of Portfolio A. The balance could not keep up with the withdrawals and the portfolio was depleted. In the post-retirement Distribution Phase, the sequence of returns concept teaches that the order of returns is important. And since no one can accurately and consistently predict when investment returns will be good or bad, it explains why the Safe Withdrawal Rate is far below the expected average annual returns of the portfolio.

WHAT IS THE NEW SAFE RATE TO WITHDRAW?
Portfolio A and B are extreme examples of both the 8% rate of return and a 5% distribution, but Portfolio A illustrates that you probably need to take a lot less money than you currently take. Most experts agree you should not take out 5%, probably not even 4%, and some are actually arguing vehemently for 3%. Historically, 4% has been widely accepted as the initial starting point, but new research indicates that perhaps 3 to 3.5% is more appropriate. In fact, Morningstar, a leading provider of independent investment research, recently stated that they believe, looking forward, the safe withdrawal rate is actually 2.7%.

A decline in investment value, especially early in retirement, can have a significant impact including a reduction in retirement income or the premature depletion of investments. Our advisors would be happy to work with you to implement strategies which strive to minimize risk with a goal of providing dependable, long-term income so you can have a comfortable retirement.

The rules of retirement are changing. Our advisors work closely with our clients to make sure they are informed and ready for the future... and not about to board the Titanic!

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Investing involves risk including loss of principal. No strategy assures success or protects against loss. Hypothetical examples listed are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. © 2018 by Mark D. Kemp & Todd A. Little. All rights reserved. Distributed by Kemp Harvest Financial Group®.

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