The Sequence of Returns Risk (SORR) is the risk that you run out of money before you run out of life because, despite having adequate average returns in retirement, the crummy returns came first. The truth is that many successful WCIer retirees have or will have enough money that they don't have to worry about SORR. So, when discussing this subject, it's important to recognize who doesn't have to worry about it.

Let's say someone has JUST enough to retire safely and maintain their spending. We'll call that “25X,” meaning that, per the 4% guideline, they have 25X what they need to spend from their portfolio each year to maintain their lifestyle. If that person can work, save, and invest for a few more years, they'll have far more than 25X. Imagine that 25X is $3 million (meaning someone is going to pull $120,000 per year from the portfolio). If they're saving $100,000 per year and earning 8% a year on their portfolio, how long does it take to go from 25X to 50X? It's not hard to calculate.

30X = 1.7 years
33X = 2.6 years
40X = 4.6 years
50X = 6.9 years

I mean, some people will go from 25X to 33X just in the time it takes to sell their practice or make sure their patients have a new doc or while waiting for their spouse to wrap things up at their job. It's only 18-36 months. Those people—who are a huge percentage of WCIers, especially when combined with those who hit “enough” long before they were done working—are not who we are talking about in today's post. In this post, we're talking about those who punched out RIGHT when they had enough. Barely enough. Enough, but not anything extra.

A Case Study

Today, let's consider a case study of somebody who just barely has enough and how they deploy those assets to ensure a comfortable retirement. Just to keep it simple, we'll use a somewhat traditional couple. He was an internist who worked hard his entire career, and she stayed at home and raised the kids. They're both 62, and they want to retire today. They have a $2.5 million portfolio and a paid-off home, and the kids have gone through college and are on their own.

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Start with Cash Flow

Like any good financial plan, we'll start with cash flow. Their house and cars are paid off, but they're not hyperfrugal by any means. They like a nice dinner now and then and love to travel. They assess their actual spending and make some projections, and this is what they think their annual budget after retirement will look like:

  • Income taxes: $15,000
  • Property taxes: $10,000
  • Health insurance: $18,000
  • Other insurance: $5,000
  • Groceries: $12,000
  • Utilities: $5,000
  • Household needs and maintenance: $5,000
  • Medical costs: $5,000

Total of fixed expenses: $75,000

  • Restaurants: $3,000
  • Hobbies: $5,000
  • Travel: $30,000
  • Gifting and charity: $7,000

Total of variable expenses: $45,000

Grand total: $120,000

At first, you might think this couple doesn't have enough to retire, right? They want to spend $120,000 a year, but they don't have 25 x $120,000 = $3 million. They only have $2.5 million. They're $500,000 short. Surely they have to work longer, right? Well, not necessarily. They have one more source of income we have not yet discussed: Social Security. How much will they get in Social Security? He checks his statement and runs the data through OpenSocialSecurity.com. They figure if he stops working today but waits until 70 to start taking the money, he'll get about $36,000 in Social Security each year. She will qualify for half of his benefit, so that's $18,000, a total of $54,000. Now, that $2.5 million, which should provide $100,000 per year at 4%, seems like plenty.

But there's still a gap of eight years before that Social Security income begins. They're tempted to just start it at 62. But they're both in great health, and she has grandparents who lived into their 90s and even one grandma who died at 102 last year. Since they figure they barely have enough, they wisely choose to delay until 70.

They worry about SORR and they worry about this gap, so they want to dedicate some assets to help alleviate both of those concerns without reducing their spending during these go-go years of their 60s.

They price immediate annuities and discover that a joint annuity will pay about 6.7%. They think that might be part of the solution, but maybe it's better to wait a little longer until their portfolio grows a bit and the yields go up as they age.

They've heard of TIPS ladders and think that might be a great solution for them. They decide to cover the eight-year gap before Social Security kicks in with a TIPS ladder. Given the safety of a TIPS ladder, they figure that it will also reduce their Sequence of Returns Risk. But how much will it cost? TIPS are yielding about 2% real right now, so they figure they can certainly buy a TIPS ladder that will cover their fixed expenses just by dedicating $75,000 (or, more likely, slightly less) per year to the TIPS. Then each year as the TIPS mature, that's what they'll spend. That'll be $75,000 * 8 = $600,000, leaving them with $1.9 million in the portfolio. They decide to invest the rest of the portfolio pretty aggressively, with an 80/20 mix of stocks to bonds.

What withdrawal rate will they need from the portfolio to cover their $45,000 per year in variable expenses?

$45,000/$1,900,000 = 2.4%.

That certainly seems very safe. So, off they go into retirement.

At age 65, they sign up for Medicare, which cuts their health insurance costs from $18,000 to just $6,000.

What Happens at Age 70?

Eight years later, they've been through one nasty bear market and one more trivial one, but they've mostly recovered from both, even with their ongoing spending. They now have $1.8 million left in the portfolio. The TIPS are all gone. Now what?

They qualify for Social Security, and it's $54,000 per year, guaranteed by the government and indexed to inflation. That doesn't cover all of their fixed spending, though, which has increased with somewhat severe inflation from $75,000 per year to $95,000 per year despite the decreased health insurance costs. What about those immediate annuities? Let's go take another look at them.

Now, those annuities pay 7.9%. That's not indexed to inflation, but it's still twice what the “4% guideline” allows. They decide to buy two $250,000 joint annuities from two different insurance companies since their state annuity guaranty organization only covers $250,000. That $500,000 will pay them $40,000 per year. Now, they have $94,000 of their $95,000 in fixed expenses covered. They figure that's probably close enough.

That leaves them $1.3 million in their portfolio. Their variable expenses are also increased somewhat due to inflation, and they haven't slowed down yet with their travel. From their portfolio, they need $57,000 to cover their variable expenses plus that $1,000 in fixed expenses.

($57,000 + $1,000)/ $1.3 million = 4.5%.

That seems a little high, right? It's well over 4%. But they're also 70. If you go back and look at the Trinity Study, the 5% column really doesn't look too bad until you get out to 25 or 30 years.

How Much Can I Spend in Retirement

They decide to cut back on their investment risk a little and go from an 80/20 portfolio to a 50/50 one. That shows a success rate of 94% at 20 years and 83% at 25 years. They figure that'll get one of them to 95, and they anticipate slowing their spending within the next decade anyway as they move into the slow-go years. So, they press forward with that 4.5% withdrawal rate.

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How Are They Doing at Age 75?

They've now hit age 75. He's developed a few medical problems that keep them from traveling nearly as much, and they've hired out the lawn care, snow shoveling, and some housekeeping. Their fixed expenses are up to $120,000 per year. But their variable expenses are down to just $40,000 per year for a total of $160,000. Meanwhile, their portfolio did just fine, with only one brief bear market, which their 50/50 portfolio weathered. That $1.3 million actually grew to $1.5 million despite the withdrawals. However, their guaranteed income sources are not generating $120,000 per year.

Those annuities are still just pumping out $40,000 per year, and the Social Security has increased to $63,000 per year. They decide it might be wise to buy another immediate annuity. They're pleased to discover that they now yield 8.4%. They buy another $250,000 immediate joint annuity, which pays $21,000 per year, leaving them with $1.25 million in the portfolio.

Now, their guaranteed income covers $63,000 in Social Security plus $61,000 in annuity income, for a total of $124,000 per year, a little more than their fixed expenses. They need just $36,000 from their portfolio, but given the portfolio size of $1.25 million, that's only a withdrawal rate of 2.9%. No problem, especially given they are now 75.

He Dies at 83

Unfortunately, he was diagnosed with metastatic bladder cancer at 81 and lost the fight at 83. With the assistance of home health, she nursed him through his final months. After the funeral, she got together with her two daughters and her son to assess her financial situation. She is still in pretty good health, and she would even like to do a little more traveling, go on some cruises, and do some other stuff she hasn't had the chance to do the last couple of years. But she realizes that two bad things have happened to her finances with his death.

  1. She loses her Social Security benefit and takes his, essentially cutting her Social Security income by 33%.
  2. Her tax bill just went up now that she has to use the single brackets, basically offsetting all the savings in groceries and insurance costs from his passing.

Luckily, they bought joint annuities, so that income, while not indexed to inflation, at least isn't reduced on a nominal basis. Her guaranteed income is now

  • Social Security: $53,000
  • Annuities: $61,000

The portfolio has also been through a bear market, and it had to be tapped significantly to pay for assistance with in-home care in his last year. It's down to only $1.1 million.

Her fixed expenses are $140,000. Variable expenses are $30,000. She will need $140,000 + $30,000 – $53,000 – $61,000 =$56,000 from the portfolio. That will be a 5.1% withdrawal rate, which is fine for an 83-year-old. But she decides she really likes that annuity income, so she looks into another one. At 83 on just her life, it now pays 13.6%, so she annuitizes another $250,000. That increases her guaranteed income to $53,000 + $61,000 + $34,000 = $148,000. She only needs $22,000 from her $850,000 portfolio, a withdrawal rate of just 3.3%.

She Goes into a Nursing Home at 95

At 95, age has really caught up with her, and she requires full-time nursing care. Her portfolio has actually grown back to $1 million, and she is getting $76,000 from Social Security and $95,000 from the annuities. Her family decides to sell her home, netting another $800,000 for the portfolio. The nursing home costs $175,000 per year, so $171,000 comes from her guaranteed income and the other $4,000 is easily obtained just from the income on her $1.8 million portfolio. She spends and gives a little bit of money away with warm hands and then dies two years later with $1.6 million left, which is divided among her children.

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Lessons Learned

Plenty of lessons can be learned from this case study. Let's go through a few.

  1. SORR doesn't usually show up: On average, retirees who withdraw 4% a year have 2.7X the amount they retired with 30 years earlier. This couple did worse than average, but they still didn't run out of money. They started with $2.5 million and died with $1.6 million. Their spending varied over the years, but they made it through several bear markets without imploding.
  2. You need a plan to bridge to Social Security: This couple bridged the gap with a TIPS ladder, which I think is probably the best approach for most of those retiring prior to taking Social Security with just enough.
  3. Delaying Social Security to 70 is a good idea: It would have been easy to take Social Security at 62, but the delay provided much more income later. And that income was indexed to inflation. That delay also provided the widow with a significant benefit as it guaranteed a good portion of her later income and indexed it to inflation. Her original benefit was $18,000 (half of his), but by the time she died, she was getting $76,000!
  4. SPIAs are best laddered: SPIAs can provide a lot of income when you don't buy them until 70 or so, and “laddering” them by buying multiple SPIAs at different times from different companies allowed this couple to continue to cover a significant portion of their fixed expenses with guaranteed income.
  5. Joint annuities are a bet on long widowhood: This couple purchased most of their annuities as joint annuities, which worked out really well when she faced a 14-year widowhood. They could have received more income initially if they had purchased individual annuities, but that would have resulted in her fixed income going down substantially right when the Social Security benefit fell and taxes went up.
  6. Withdrawal rates of more than 4% often work out fine: This couple withdrew more than 4% for years at times, and things still worked out fine for them. Historically, that is the case most of the time. Four percent is supposed to be a minimum, not a maximum. Keep that in mind as you work your way through retirement.

What do you think? How would you deploy your assets if you barely had enough to sustain your desired lifestyle in retirement? Should this couple have done anything differently?