You will be able to explain sequence of returns risk and name ways to reduce it.
If you plan to live off your investments, the years just after you stop working carry a particular danger. A weak market in those first few years can leave lasting damage on your plan, even when the returns over the full period end up looking healthy. This is called sequence of returns risk, meaning the risk that poor returns land early in your withdrawal years, at the point where they cause the most harm. Of all the risks facing someone who lives off a portfolio, it is the largest one during the opening years of the plan.
Picture two friends who leave work in the same month (an invented example, with the sums checked step by step). Both hold S$1,000,000 in the same kind of portfolio, and both take out S$40,000 a year, at the start of each year, over ten years. Their plans are identical in every respect.
Their yearly returns after inflation are also the same set of numbers. The first friend receives them in this sequence: minus 20%, minus 10%, 5%, 10%, 15%, 10%, 10%, 5%, 10%, 15%. The second friend receives the identical returns reversed: 15%, 10%, 5%, 10%, 10%, 15%, 10%, 5%, minus 10%, minus 20%. Added up and divided by ten, each set gives a simple average of 5% a year. For her the crash arrives in the first two years, and for him in the last two.
Follow her first two years. She takes S$40,000 from S$1,000,000, leaving S$960,000, and a 20% fall brings that down to S$768,000. Another S$40,000 withdrawal leaves S$728,000, and a 10% fall reduces it to about S$655,000. His first two years run the other way: his S$960,000 rises 15% to S$1,104,000, and after his second withdrawal the remaining S$1,064,000 rises 10% to about S$1,170,000.
By the end of year ten she holds about S$886,000 and he holds about S$1,123,000, a difference of nearly S$240,000 that comes from timing alone. Had neither of them withdrawn anything, both would have ended with about S$1,537,000.
When you are still saving and taking nothing out, the sequence of returns has no effect on where you end up. Money invested and left untouched arrives at the same final figure whichever order the gains and losses came in, which is why the two friends would have matched each other at about S$1,537,000 without withdrawals. Taking money out each year is what makes the order start to matter, and once you are withdrawing it matters a great deal.
Each withdrawal is a fixed sum, but you raise it by selling units. In a year when prices have dropped, every unit is worth less, so you have to sell more of them to raise the same amount. A drop in value on paper is not yet a realised loss; it becomes one when you sell to cover your bills. This is locking in losses: the units you sold cheaply have left the portfolio, and when prices recover they gain nothing for you because you no longer own them.
Heavy selling at low prices leaves a smaller base for the rest of the plan to grow from, and the good years that follow cannot fully make up for it. From year three onwards the first friend had strong returns, but they were applied to a far smaller sum than the second friend had at the same stage.
Losses near the end do less harm for two reasons. By then the portfolio has done most of the growing it will do, and there are fewer years left that it has to pay for. When his crash came, his portfolio had been growing for eight years and needed to cover only two more withdrawals.
Market history follows the same pattern. Bengen's result, which you met in lesson 2.1, was set by the worst historical starting years, and the retirees who ran into trouble were mostly those who hit a bad market, or a run of high inflation, close to the start.
You have no control over the order in which returns arrive, though you can change how much your plan depends on it.
The first way is a buffer, meaning a few years of spending kept in cash, deposits or short-term government securities. When a bad year comes, you pay your bills out of the buffer and do not sell shares. You leave the shares alone until they recover, then top the buffer back up during better years. Sizing it properly is covered in module 6, lesson 6.3, "The cash buffer that buys you time".
The second way is a spending rule, which is a rule you set in advance that adjusts your withdrawals after a bad year. Bengen's model assumed the retiree increased spending in line with inflation every year, including the year straight after a crash. The simplest rule drops that inflation increase for the year after your portfolio has fallen. A firmer version also cuts your flexible spending by a set share until the portfolio has recovered. With either version, you end up selling fewer units at low prices.
The remaining two options work on the early years directly. Doing a little paid work for the first few years means a poor start can be met with earned income instead of sales of units. Keeping your withdrawal rate lower at the beginning, and raising it later if things go well, has a similar effect. Each of these makes the outcome of your first few years depend less on luck.
A spending rule is only useful if you actually follow it as markets fall, and a falling market is when clear thinking is hardest. The pull at that moment usually goes one of two ways: panic and sell everything, or carry on as if nothing has happened. Writing the rule down ahead of time, while you are calm, means the decision is already made when the pressure arrives. To write yours:
Get out your spending split from lesson 1.2, so you can see which parts of your spending are flexible. Decide in specific terms what counts as a bad year, such as a fall of a certain size in your portfolio's value over twelve months. Say exactly what you will cut: the inflation increase, a fixed share of your flexible spending, or one particular item such as a holiday. Say when you will return to normal spending.
Priya, who you met in module 1, has about S$15,500 of flexible spending in her made-up base (an invented figure). Her rule says that after a year in which her portfolio falls by a large amount, she skips the inflation increase and cuts her travel budget in half until the portfolio is back where it started. Because the rule names the trigger, the cut and the point at which it ends, she can act on it under pressure without working it all out again.
Your rule will depend on your own flexible spending and how much of it you could give up for a year or two. Have your split from lesson 1.2 to hand when you write it.
Write down the spending rule you would follow after a year in which your portfolio fell sharply.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).