Two Retirees, One Set of Returns, Very Different Endings

Picture two people who each retire with $1 million. Each withdraws $50,000 in the first year and raises that amount 2% annually to keep up with inflation. Each portfolio goes through the same two 15% declines and earns 6% in every other year of an 18-year stretch.

The only difference is timing. One investor takes the losses in years one and two, and the other takes them in years ten and eleven. In the Schwab Center for Financial Research's illustration, the early-loss investor runs out of money far sooner.

That surprised us the first time we sat with it. The returns are the same list of numbers, just shuffled, and a plain average of those returns is identical for both people. The outcomes still diverge sharply, because the portfolio is being drained while the market moves.

This is sequence-of-returns risk, and it matters more now than it did a generation ago. A retirement that starts at 65 can easily run 25 or 30 years, and the first few years carry a disproportionate share of the danger. Anyone within a few years of retiring, or already there, should understand how it works before the next drawdown rather than during it.

Why Withdrawals Turn a Dip Into a Hole

A person still saving for retirement can treat a falling market as a sale. New contributions buy more shares at lower prices, and the eventual recovery lifts a larger pile. Retirees live on the opposite side of that trade.

When you need a fixed amount of cash and prices are down, you have to sell more shares to raise it. Those shares are gone. When the market recovers, they are not there to recover with it.

Schwab describes the cost as twofold. Selling in a slump drains savings faster, and it leaves fewer assets to generate growth in any rebound. A decline that arrives late in retirement does less harm for the same reason. There are fewer years left to fund, and earlier gains have already paid for much of the spending.

Many people picture a retirement portfolio as a lump of cash that shrinks steadily toward zero. That isn't how it works. A real portfolio is a mix of investments producing income and growth, and the hope is that growth refills part of what you take out. Sequence risk is what happens when a bad market interrupts the refilling during the years you can least afford it.

Running the Numbers on the First Two Years

Start with the early-loss investor and assume withdrawals come at the start of each year. In year one, $50,000 leaves the portfolio, which drops it to $950,000. A 15% decline brings that to $807,500.

In year two the withdrawal rises 2% to $51,000, leaving $756,500. Another 15% drop takes the balance to $643,025. After two years the investor has pulled out $101,000 and holds roughly 64% of the starting capital.

Now look at what the third withdrawal means. It will be $52,020, which is about 8.1% of the $643,025 balance. We usually discuss a sustainable retirement withdrawal in the neighborhood of 4%, so this investor is spending at double that pace before the market has even begun to recover.

The late-loss investor looks very different at the same age. By our rough arithmetic, nine years of 6% returns with those same withdrawals leave a portfolio of just over $1 million going into the downturn. Growth has funded the withdrawals, so the principal barely moved. When the losses finally land, there is a large base to absorb them, and fewer years remain to fund.

The Slow Climb Back

A natural reaction is that a rebounding market should repair the damage quickly. Schwab tests this with a second pair of investors who both suffer 15% declines in years one and two and then earn 6% a year afterward. What separates them is how much they withdraw.

An investor who cuts withdrawals to a 2% rate is back to the starting balance after roughly 11.5 consecutive years of 6% gains. Their counterpart who keeps taking 4% needs 28 straight years of 6% gains to recover fully. Twenty-eight years is longer than most retirements.

Continuing withdrawals act as a headwind. In a rising market each dollar of spending costs fewer shares than it did during the slump, but the shares sold early are already out of the portfolio. An investor with the higher withdrawal rate is climbing a hill while handing out part of the gain at every step.

This also explains why average-return thinking misleads retirees. A projection that says "6% a year over 25 years" describes a smooth path that almost never occurs. Whether the money lasts depends on the order of good and bad years, and that order is unknown ahead of time.

What This Means for DIA, QUAL, TIP, MS and GS

Concentrating on equities during the first years of retirement makes the sequence problem sharper, since stocks are where deep declines tend to occur. A broad large-cap vehicle like DIA, which tracks the 30 stocks of the Dow Jones Industrial Average, holds a diversified set of established companies. It is price-weighted, which means a high-priced stock like Goldman Sachs (GS) carries more influence on the index than its size alone might suggest. It still falls hard in a bear market, and a retiree selling DIA shares into that fall is living the early-loss scenario.

QUAL, which holds large and mid-sized US companies screened for quality traits such as high return on equity, stable earnings and low leverage, tilts toward businesses that may hold up better under stress. We say may because factor funds still carry full equity risk, and a quality tilt gives no guarantee about the depth of any single drawdown. It can make a stock sleeve somewhat less jumpy, and that has some value for a retiree.

TIP, an ETF holding Treasury Inflation-Protected Securities, addresses a different risk, which is inflation eating into those 2% annual withdrawal increases. It is not a substitute for the cash and short-term bond reserve Schwab describes. Its holdings have intermediate maturities, so rising interest rates can push its price down, and Schwab's own disclosures note that fixed income carries greater loss of principal when rates climb.

Individual bank stocks such as Morgan Stanley (MS) and GS deserve a separate mention. Their earnings swing with market activity, and a good part of their wealth management revenue depends on client asset levels. A retiree who owns these names directly is stacking a cyclical holding on top of a withdrawal plan that already depends on market health. We would treat a single-stock position like that as a small piece of a diversified portfolio rather than a core holding for someone spending down.

Building the Reserve Before It Is Needed

Schwab's main defense is a short-term reserve, and the structure is concrete. Keep one year of expenses, net of other income such as Social Security, in cash investments. Then hold another two to four years of expenses in high-quality short-term bonds or short-term bond funds.

Take a household that needs $60,000 a year from its portfolio after Social Security. The reserve would be $60,000 in cash and between $120,000 and $240,000 in short-term bonds, for a total of $180,000 to $300,000. On a $1.5 million portfolio, that is 12% to 20% set aside to cover expenses through a rough stretch.

The purpose is to avoid selling stocks while they are down. If equities fall 25%, the household spends from cash first, then from the short-term bonds, and leaves the stock sleeve alone until prices recover. Schwab notes that households can count this allocation as part of the retirement portfolio, so it does not have to sit outside the plan.

There is a cost. Cash and short-term bonds usually earn less than stocks over long periods, so a bigger reserve means less growth in good years. We see that as a straightforward trade: we give up some expected return to buy a lower chance of having to sell at the worst moment. Before buying any bond fund for this purpose, we check the fund's prospectus for objectives, risks, charges and expenses.

Spending Flexibility When There Is No Reserve

Some retirees reach the starting line without a reserve, or are already deep into retirement when a decline hits. Schwab suggests that these retirees cut back on what they take out of the portfolio. They can forgo the annual inflation adjustment, postpone large purchases, or trim spending for a few years.

Even modest changes matter, given the second set of examples. The gap between a 2% and a 4% withdrawal rate was the gap between an 11.5-year recovery and a 28-year one. A temporary reduction in the first two or three years after a drop does the most good, because that is when each dollar withdrawn costs the most shares.

A practical way to frame this is to decide in advance which spending is fixed and which is flexible. We find housing, insurance and medical costs hard to change. We can usually postpone travel, gifts, a new car and home projects. Writing that split down while markets are calm makes it much easier to act when they are not.

Timing deserves attention too. Building a reserve gets harder in the middle of a downturn, since the only things to sell are the assets that have fallen. The better window is the stretch of years before retirement, and ideally the year or two before the first withdrawal, when a person can shift gradually from stocks into cash and short bonds with less pressure.

A Short Plan for the Next Five Years

The central lesson is that the order of returns matters most when money is leaving the portfolio. Two investors with identical average returns can reach opposite endings, and the early years of retirement carry the most weight. We think that justifies planning for a bad start even if one never arrives.

For readers within five years of retiring or already retired, a few steps are worth taking. First, calculate annual spending after Social Security and other income, because the reserve is sized off that number. Second, move toward one year of expenses in cash and two to four years in high-quality short-term bonds, at a pace that suits your tax situation and comfort.

Third, check how much of the stock sleeve sits in a single fund or a few individual names. DIA, QUAL, MS and GS each behave differently in a slump, and a retiree should know which of them is carrying the portfolio's equity risk. Where inflation worries drive the decision, TIP can help with that specific problem, though not with the sequence problem.

Finally, write down a spending response plan: which expenses get cut or delayed if stocks fall 20% or more, and for how long. Review the plan once a year, and revisit the withdrawal rate if the portfolio falls well below its starting value early on. All of this is general education, so individual situations call for a conversation with a qualified tax or financial professional.