Pamela’s portfolio sees a 15% return each year for the first three years of retirement, then sees negative returns for the next three years of -5%. Returns are then 5% each year thereafter. The average annualized return for the full period is 5%.

By contrast, Nancy’s portfolio experiences a -5% return each year for the first three years of her retirement, followed by positive returns of 15% for the next three years. Similarly, Nancy’s portfolio returns 5% each year thereafter, and her average annualized returns are also 5%. 

Although the long-term average annualized return for both Pamela and Nancy is 5%, the sequence that those returns occurred produces significant differences in the long-term assets available to each of them. Because of the early negative returns in Nancy's retirement, combined with persistent annual withdrawals, her portfolio is subject to running out far sooner, even though she saw strong performance in the years after. 

Challenges in addressing sequence of returns risk

A variety of strategies have been suggested over time that are aimed at trying to address this risk, and reduce its impact. Some popular suggestions have been offered, including:

• Allocating holdings to more conservative assets. A portfolio that includes, and/or gradually increases holdings in bonds, cash, or other assets. The objective here is to reduce volatility, and include low-correlation assets that may reduce the impact of sharp market declines.
  
  
• Cash wedge / bucketing strategies involve keeping up to one to three years of living expenses in cash and/or segmenting your portfolio into different "buckets" for short-, medium-, and long-term needs. The aim being to lessen the impact of required withdrawals during declining equity markets.
  
  
• ‘Safe’ withdrawal rate is an approach that targets a specific percentage or dollar amount each year. The concept was made popular because it provides a simple planning rule of thumb in an attempt to preserve portfolio longevity.

There are some potential benefits of the above noted approaches through their simplicity and attempts to reduce volatility. However, this could also lead to lower potential long-term returns, and less tax-efficiency in non-registered accounts. There is also growing consensus that safe withdrawal rates may no longer be appropriate due to taxation, low-interest-rate environments, inflation volatility, longer lifespans, and lack of spending flexibility—the factors that matter in proper financial planning, and why you need a financial plan.

When considering the fact that funds are typically needed over a long time horizon in retirement, the impact of inflation, taxation and total returns matter. Placing a substantial amount into higher-taxable, lower-return assets in “normal” markets will create a drag in performance if allocations to these assets exceed what would otherwise be appropriate for your risk tolerance. In addition, a safe withdrawal rate also creates potential for a sizable amount to be left over in your final estate, thus reducing available spending potential during your lifetime.

Dynamic withdrawal strategy - A more pragmatic approach 

A more practical solution involves a dynamic approach to portfolio withdrawals that adapts as necessary to market valuations, lifestyle changes, and spending flexibility. This flexibility directly addresses the sequence of returns risk, while the impact from variability in returns can be reduced by adjusting spending based on portfolio performance. Here’s how:

• Spending is reduced when portfolio performance is less than the average expected return, i.e what is planned for.
  
  
• Spending is increased modestly after years of better-than-average portfolio performance. This could include an amount originally planned for, plus some profits in excess of the average expected return for the year.

The ideal amount of withdrawal every year can be identified as a function of the portfolio’s value, return, and the number of remaining periods projected. This approach to adjusting spending based on market conditions and the remaining projected retirement period can then result in increasing the amount available for spending while decreasing the risk of running out of money, which addresses some of the problems associated with safe withdrawal rates. Flexible spending and withdrawals spreads that risk out by reducing spending after poor returns and increasing it after positive returns. This means making some adjustments to spending along the way, which minimizes the risk of running out of money.

When it comes to finding an optimal approach, there is no one-size-fits-all solution. Identifying and tracking spending is an important step in managing your finances on your own terms. In our article Why a spending plan beats budgeting, we examine the merits of understanding your cash flow, where spending can be categorized into two areas: needs that include housing, food, transportation, and wants, which may include dining out, vacations, entertainment, and non-essential shopping. To get an accurate estimate of your spending, you should review your expenses over a period of time to help identify what these might be for you and your family.

In practice, it’s difficult, if not impossible, to account for every future event that might impact your lifestyle expenses and income needs. In fact, this is the reason why every financial plan is wrong – and that’s OK. A financial plan is an essential tool for setting goals and creating a roadmap for your financial future. However, it should not be thought of as a rigid, step-by-step GPS route, but as a flexible compass. The purpose of the plan is not to predict the future, but to guide your decisions and help you course correct when things inevitably get off track. Just like life, the one certainty about any financial plan is that it can change. This isn't a sign of a bad plan, but rather a reflection of the unpredictable nature of each individual's circumstances and needs.