# The Sequence of Returns – The Roulette Wheel of Retirement

So here you are, crossing the threshold from earning a living to going into retirement. You worked hard for many years. You built a sizeable, diversified investment portfolio. You hedged your bet by purchasing life insurance and long-term care insurance. Your will and other estate planning documents have been updated to reflect your current goals and financial situation. Everything’s in place, or so you think.

Welcome to the roulette wheel of retirement, otherwise known as the “sequence of returns.” If you haven’t planned for this financial phenomenon, your retirement could be quite different than you envisioned. To illustrate this important concept, let’s take a look at three hypothetical scenarios. In each one we’ll use the following five assumptions:

1. Retirement age: 65

2. Portfolio value: $500,000

3. Annual withdrawals: $25,000, or 5% of the initial portfolio value,

increasing by 3% each year

4. Life expectancy: 25 years, or until age 90

5. Average rate of return: 7%

The last assumption is the most critical one and can wreak havoc on your portfolio if you only rely on a retirement asset planning strategy during your retirement years.

Let’s start with **Scenario #1 – 7% Return Each Year**. While this scenario never occurs in real life, it’s often used for illustration purposes. Once you review **Scenario #1 – 7% Return Each Year**, you will see that even after taking out withdrawals that begin at $25,000 and more than double to $52,000 at age 90, your portfolio value increases from $500,000 at age 65 to $576,000 at age 78 and then gradually declines in value to $462,000 at age 90. You’ve taken distributions totaling $964,000 and your portfolio has earned $926,000 over 25 years. *Nice result!*

**Scenario #2 – Good Early Years** assumes that you are fortunate enough to retire at the beginning of a bull market where your investment returns exceed your inflation-adjusted withdrawal rate of 5% for several years, you experience a couple of years of negative rates of return, and a bear market kicks in your final three years, resulting in negative rates of return each year. Per **Scenario #2 – Good Early Years**, although it doesn’t occur in a straight line, your portfolio increases from $500,000 at age 65 to a peak of almost $1.5 million at age 87, with a final value of $921,000, or double the value of Scenario #1, at age 90. Like Scenario #1, you’ve taken distributions totaling $964,000 and your portfolio has earned $1.385 million over 25 years. *Life is great! *

So far, so good. To illustrate **Scenario #3 – Bad Early Years**, let’s simply reverse the order of investment rates of return that we assumed in Scenario #2. As in Scenario #1 and Scenario #2, over 25 years, we’re going to end up with the same average rate of return of 7%, however, the first three years are going to be bumpy, to say the least. Unlike Scenario #2, where your portfolio value increases by $208,000 the first five years, going from $500,000 at age 65 to $708,000 at age 70, per **Scenario #3 – Bad Early Years**, it decreases by $224,000, going from $500,000 at age 65 to $276,000 at age 70, or a *swing of $432,000* during the same period.

Your portfolio continues to decrease in value each year until it is depleted at age 81. Instead of taking distributions totaling $964,000 as you did in Scenarios #1 and #2, your total distributions over 25 years are only $541,000. Furthermore, instead of realizing portfolio income totaling $926,000 in Scenario #1 and $1.385 million in Scenario #2 over 25 years, your total portfolio income is a measly $41,000. *Yikes!*

In both Scenario #2 and Scenario #3, there are negative rates of return in only five, or 20%, of the total of 25 years of retirement. Two years of negative rates of return out of ten years, on the average, is fairly typical for long-term historical rates of return for a diversified equity-based portfolio. As you can see, in Scenario #3, it doesn’t matter that 80% of the returns were positive, nor is it relevant that there was an average rate of return of 7%. As a result of the portfolio being depleted at age 81, the hypothetical individual in this situation wasn’t able to experience the 11.4% average rate of return during the final nine years.

The most important factor in Scenario #3, and the #1 risk to any retirement asset plan, is the sequence of returns. While you have no control over this investment phenomenon, you don’t need to play roulette with your retirement assets.

Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.