Managing the Sequence-of-Returns Risk


Imagine the day you retire.

You’ve been working and investing for years leading up to this point.

Not just money, but also countless hours went into planning and setting up your retirement plans.

Just for the market to crash as soon as you retire.

It’s unfortunate, since the market is outside of your control.

On the other hand, you are not powerless.

Today, you will discover how to manage the sequence-of-returns risk, and why your emergency fund may be the key to a stress-free retirement.

Listen now.

Show highlights include:

  • The “Wants and Needs” method to knowing your monthly budget ([7:07])
  • How to reduce the risk of the market burning your savings with your emergency fund ([8:50])
  • 3 ways to cover your basic expenses for the rest of your life ([10:49])
  • How you can afford the things you enjoy (even if the market is crashing) ([13:20])
  • How to turn your inheritance into a life-changing legacy for your family ([15:07])


DLP062 PC - Managing the Sequence-of-Returns Risk



Do you want a wealthy retirement without worrying about money? Welcome to “Retire in Texas”, where you will discover how to enjoy your faith, your family, and your freedom in the State of Texas—and, now, here’s your host, financial advisor, author, and all-around good Texan, Darryl Lyons.


Darryl: Hey, this is Darryl Lyons, CEO and co-founder of PAX Financial Group. Thank you for tuning in today to Retire in Texas.

Let me provide you the legal disclosures before we get started. This information is general in nature only. It’s not intended to provide specific investment, tax, or legal advice. Visit PAXFinancialGroup.com for more information.

Remember, PAX Financial Group helps support this podcast. They sponsor it, so if you need to speak with an advisor, all you have to do is text “TEXAS” to 74868. It’s real simple, on your phone, “TEXAS”, 74868, an advisor. We have nine advisors. They are PAX advisors and they have hearts of a teacher, and so if you need to connect with one, that’s an easy way to do it. [01:09].3]

So, thanks for tuning in today, another solo show. Really enjoying the solo shows. I hope you are, too. I certainly appreciate your feedback. So far, so good. I will bring in some other guests. I’ve got some more guests lined up here soon as we start the new year, but I do want to address those that are thinking about retirement or even are in retirement. There’s five questions that you need to ask yourself, and so we’re going to address those five questions today, and the problem we’re trying to solve is this. The five questions, the answers to those five questions, will help solve this problem.

This problem other than the emotional and the almost psychological and health sides of retirement, those are real and I’ve spoken about them quite a bit, but when it comes to the financial side of retirement, this could be your biggest risk, I mean, right up there with health risk. But, really, this could be your biggest risk and it’s known as the sequence of returns. [02:09].8]

Some of you guys have heard about this, but let me unpack it so we’re clear. Sequence of returns is when you retire, and the day after you retire, the market crashes and you spend the next year taking withdrawals from your investments to support your standard of living, and as you are taking withdrawals each month from your investments and the market is simultaneously falling, you are eating your seed, so that when the market recovers, you don’t have as much seed to participate in that recovery. The market is crashing and simultaneously you’re taking withdrawals, so you’re selling your investments low. [02:59].2]

This, the math associated with this risk, has been pored over by academics for years and it has been identified and called sequence-of-return risk and it is one of “the’ biggest risks for retirees, so I’m going to address five questions that, collectively, the answers to these questions minimize that risk.

Let me also provide you some more context to this risk, so let’s put a million dollars in place, and say you have a million dollars and you need to live off this million dollars and you want 4%, which most academic research would suggest 4% is the appropriate withdrawal rate. I’ve seen plenty of studies on this. I’ve seen 5%, I’ve seen 3.5%, but 4% is the general consensus here.

So, the first year you would take out $40,000 a year. That’s $3,333 a month. I think I’m pretty close there. $40,000 a year, you’re living off this million. You’re not touching the principal, right? That’s the hope. Hopefully, you’re making more than 4% on your investments, but we know that investments do fluctuate, the returns. [04:05].2]

The next year you take out not 40,000, [but] 40,800. Why? Because you’ve added some inflation piece to that and I’m giving a 2% inflation in this math, which is very, very off in today’s context, but, historically, in the last 10 years, that was the right number, but could be 3% or 4%, 5% now. So, the next year, you take out 40,800, and then the year after that, you take out a little bit more and you continue to increase the withdrawal rate as a function of inflation.

This is where it becomes problematic, because as the market is crashing and you’re taking money out, you just can’t recover from that. If we look at the reality as this happens—and I can tell you after retiring hundreds of people, helping them transition in the next phase of life, I’ve had this happen a lot—I say I don’t really think it’s happened to where, and I’m recalling right here in real time, but I don’t think I’ve ever had anybody that it’s damaged their retirement, but what I will tell you is that we’ve had to navigate when somebody retired and the market crashed. [05:15].1]

I’ve absolutely had to navigate that, and we’ve navigated it well. I mean, I can think of several. I can think of one person in particular, and if you’re listening, I won’t say your name, but he always comes to me and says, “Darryl, you saved me when the market crashed in 2008.” I didn’t really save him necessarily. It was just kind of being thoughtful about his situation, but he retired at the perfectly wrong time, and so we paid attention to this sequence-of-return risk and we implemented a few strategies that helped get him through that. So, he always thanks me and I’m appreciative of that, because I need thanks every now and again, just like all of us. [05:52].4]

But suppose that somebody retired in 1999, and if you look at the 10-year time horizon from 1999 to February 2009, and if you had put your money just in the Vanguard Balanced Fund—this research you can find on Morningstar. Morningstar did this research—the rate of return, just low-cost Vanguard Balanced Fund, you’re like, Hey, I just want to keep retirement simple and I’m going to put it in this one fund, very well diversified. The average rate of return on that fund was -1.7%.

Let’s say you go into retirement in 1999, you have a million dollars, you want to withdraw 40,000 a year, and then you have this inflation adjustment on it and you lose 1.7% each year, but you’re running out of money. I mean, there’s just no way around this, and if you’re running out of money, then what’s next? I mean, are you subject to Medicaid, social security, a ward of the state, or even worse, I mean, depending on how you look at it, a ward of the family? This is really a real problem and it’s happening all the time without careful thought into answering these five questions. [06:57].6]

Let’s dive into them and these five questions connect with each other, and it’s a peculiar way of me addressing this, but I hope you can appreciate that we’re going to solve this problem, so let me jump into this. Okay, the five questions that we need to ask ourselves when we’re trying to prevent sequence-of-return risk from destroying our retirement—the first question is “How much do I need in my checking account?” The very logical, intuitive, easy question, kind of low hanging fruit.

But in order to answer this question, you’ve got to do a budget. You can’t answer the question without taking inventory of your bills, and when you take inventory of your bills, the way I’d like for you to do that is separate all your expenses out into two different categories, one of your needs and one of your wants. What are your needs? What are your wants?

Needs are, look, my standard of living would materially be different if I couldn’t pay my electric bill, if I couldn’t pay for food, if I couldn’t pay my property taxes. Those are your needs. Your wants, alternatively, are things that are lifestyle things, like going out, movies, drinks. Things like that, right? Travel. So, separate those two things out. But then you need to identify, Okay, how much do I need to keep in my checking account to cover these total monthly expenses? [08:04].1]

So, that’s the first question to ask, which is “How much do I need in my checking account?” which subsequently has a follow up question, which is “How much do I need to budget?” The budget idea is not … it’s more of just examining cash flows, because a budget, by definition, assumes that somebody is going to control your spending habits.

I mean, we’re mature adults. We should have some boundaries on our spending, and I think, at that point, as you’re planning your retirement, do not burden yourself with thinking, Okay, I’ve got to create this strict budget. What we’re doing is we’re taking inventory of the cash flows that are going out and we’re putting that money in our checking account to make sure our bills are covered. You need to make sure you’re out of debt at that point, too, or at least have a plan to be out of debt. [08:49].8]

Okay, so let’s go to the second question which builds off the first. The first question is “How much do I need in my checking account?” The second question is “How much do I need in my emergency fund?” Because we know how much we’re spending each month, and suppose, in this example, it’s $5,000 a month, we can take a multiple of that amount that’s in our checking account and apply that. The multiple would be 12. In other words, I want 12 times whatever I need monthly into my emergency funds, so 12 times that 5,000 would be 60,000.

Why 12? Okay, 12 times your monthly expenses is a lot more than what you heard growing up where you need three to six months of your monthly expenses. “Now you’re saying I need 12 times my monthly expenses?” Yes, I’m saying you need 12 times your monthly expenses.

Look, I’ve done this a while and I feel like it’s the right number. I mean, some people, I’ve seen some academics say two years, but I think one year of your expenses is very reasonable, and here’s why. This is why that’s important. First of all, if you have a health issue, it gives you a lot of runway to cover deductibles. And I’m not talking about acute issues. I’m talking about chronic issues, so it gives you plenty of runway. [09:57].2]

Two, this is going to give you a lot of stinkin’ peace of mind, and here’s what I mean by that. If you’re taking withdrawals, and we’ll talk about this in just a minute, out of your investments to live off and the market goes down, you can call your financial advisor up and say, “Hey, I don’t want to take money out of my investments right now because I heard about the sequence-of-return risk. I want to take it out of my emergency fund.”

Why can you do that? Because you’ve got 12 months of runway. You’ve got plenty of runway, so you can pause your investments withdrawals. You follow me? You can pause your investment withdrawals and take out from your emergency fund. That is freedom. That is complete freedom, because now you’re not going to subject your money to sequence-of-return risk. So, having 12 months in an emergency fund is an amazing strategy in the context of you can’t completely avoid sequence-of-return risk, but you are mitigating that risk big time.

Okay, so we’ve got the first question, “How much do we keep in our checking?” The second question, “How much do we keep in an emergency fund?” Third question, “How do we pay for our needs?” Basically, this is replacing your paycheck, the paycheck that you’re used to getting. We’ve got a cash flow worksheet on our website. We should have it up. If not, email me or email my team to be able to do this. But you can do it on any Excel spreadsheet. [11:10].7]

But when you’re looking at your needs on that budget that I told you to do, when you’re looking at your needs, I said the total budget was $5,000, but let’s say your needs in that are 2,000, just making up numbers here. You need $2,000 a month. I mean, it’s not that much. Let’s say it’s just food and some utilities, cell phone, things like that.

So, if you need $2,000 a month, you need to cover those needs with something that’s guaranteed. You need to guarantee, you need to figure out a way to guarantee that your needs are going to be met. You’ve got to figure that it’s good for your gut, it gives you peace of mind. You need to figure out a way to guarantee that your needs are going to be met for your family.

There’s only three ways that you can guarantee your needs. There’s only three ways. One is social security. You might find that social security covers your needs. You can check that box. That’s going to be the case and for a lot of people, because of social security, you’re going to get 3,000. Maybe a husband and wife can get 6,000, 5,000 or 6,000. If you have $2,000 needs, you’re like, I’ve got that box checked, my needs are covered through social security. [12:11].8]

But other people’s needs are going to be higher and social security will be lower. In that case, you might need to lean on that pension. If you’re a teacher, you’ve got that pension, TRS. But then you’ve got something called a windfall-elimination provision, which reduces your social security, so you’ve got to navigate some of that. But my main point is you’ve got to make sure that your guaranteed income supports your needs. Your guaranteed income supports your needs.

So, what’s the third thing? The third thing is an annuity. Some people have a bitter taste of annuities. I don’t mind them necessarily. I would think we use them judiciously. I think if you account for the assets that we’re responsible for families around the country, now it accounts for, gosh, I’d say, less than 5%, but we know they have a place. If your needs are too high, if you have needs of $10,000 a month and social security doesn’t cover but half of that, then you find a way to get an annuity to cover your needs. [13:03].6]

That way you can have peace of mind, saying, for the rest of my life, because pensions, annuities and social security will last for the rest of your life, if properly constructed, and that’s not difficult. It’s just being thoughtful. And knowing that your needs are covered for the rest of your life is a peace of mind thing.

So, let’s go to the fourth question. Fourth question is “How much money do I need to cover my wants?” This is vacation, dining out, whatever, enjoyable things, lifestyle things. Your wants can come from your investment portfolio and that’s perfectly fine. Every financial advisor has these real risk-tolerance questionnaires. It’s going to check your pulses and it’s going to say, “Okay, it’s I’m going to create a 60%, 40% portfolio, 60% stocks, 40% bonds.” Let’s say that’s the strategy. In that case, they should map it out, “Okay, your wants.” In this case, remember I said 5,000 is your total amount on your budget. 5,000 is your total budget. 2,000 is covered by social security. 3,000 needs to come from your investments. That’s $36,000 a year from your investments. [14:03].8]

I don’t do the math at a 4% withdrawal rate. That’s 950,000 or something like that. So, if you had 950,000, you could take out 36,000 a year and be pretty comfortable. And then the market crashes and you’d call your advisor and say, “Okay, I don’t want my 36,000. I’m going to take it from my emergency fund until the market recovers.” You see how that works?

You might want to digest this a little bit more because it’s a very critical part of avoiding or mitigating the sequence-of-return risk. If you have that, what I call a supersized emergency fund of 12 months, then you can call your financial advisor up when the market is crashing and say, “Don’t send me my withdrawals. I don’t want to eat my seed. Keep it cooking. I’m going to live off my emergency fund for a little while.” And your advisor says, “Cool, thank you, because I don’t want you to eat your seed, because then it’s not going to recover.” So, your investment portfolio covers your wants and your emergency fund is your plan, should the market crash right when you retire. [15:06].8]

Last question that you need to ask, very important question, too: “How much do I leave as an inheritance?” Now, inheritance is what you leave to somebody, but a legacy is what you leave in somebody, so let’s kind of tease that out real quick. I think an inheritance is just kind of like “Okay, by default, whatever I’ve left over,” but a legacy is being very thoughtful. “Okay, I want to leave …”

It could be $500. It could be a ring. It could be jewelry. It could be whatever. I mean, all I’m saying is be thoughtful about what you leave to the next generation and intentional, because money accentuates behavior, so if you have a child or a grandchild that’s a giver, they’re going to give more. If they’re a spender, they’re going to spend more. So, make sure that you’re intentional about the legacy you’re going to leave.

If you do have money beyond, so you’re a financial guy or gal who will run the numbers and say you have plenty of money. If they say you’ve got plenty of money, then carve out some of that money for the legacy. Say, I want to put 50,000 in my legacy bucket, or 500,000, whatever that number is. Let’s go with 50,000. You tell your advisor, “I want to put 50,000 in my legacy bucket.” [16:09].4]

What does that mean? That means that you’ve given yourself a permission slip to be more aggressive. Why? Because there’s a time horizon on that that’s different than your retirement income. For example, if you’re 65 and you’ve done good planning, and you intentionally put 50,000 in your legacy bucket and you’re a little bit more aggressive on that, if we look at life expectancy, that particular bucket of money has a 20-year time horizon, maybe 30, and if you are aggressive with it–

This is where I think people underestimate compounding because we think, oh, it’s cute, we put it in a [60:40], it’s going to earn around the same thing as maybe an aggressive portfolio. No, over time, compounded, there’s a material, hundreds of thousands of dollars of difference in returns compounded over 20 years. This is no joke. We’re pretending like, okay, we put some in here and put some over here, and this is in a 60% stock, 40% bonds. We’ll do 70% stocks, 30%. [17:09].3]

No, be aggressive with it. You don’t need it. We’ve already identified, if your financial advisor says that’s just extra, then say, “That’s legacy. I’m going to be aggressive with it because compounded returns by leaning into risk long term have historically benefited people,” and we’re talking about hundreds of thousands of dollars difference in a legacy. I don’t think this is or I don’t take this as this is just interesting. This is real, real dollars, real legacy, real difference in people’s lives, talking about leaving it to a kid.

The son-in-law is a firefighter, the daughter is a teacher, and they get an inheritance for 100,000. It’s a game changer for their stress. They can now send their kids to college, right? This is game-changer stuff. If you’re 60, 65, and you’ve mapped this out and you’ve got some legacy money, lean into that risk. [18:03].0]

The other thing it does is, look, it’s fun. I’m not going to lie. When the market is going up and you see this little portfolio taking off, that’s good for you, and when you see it crashing when the market goes down and you can still enjoy life because you’ve done good planning, that’s good for you, too. Whatever you put in your legacy bucket is healthy for you long term and it makes a significant difference in the lives of your family.

Man, that’s a lot of content. I know I’m giving you a lot here, but I hope maybe you can go back and digest it. Let’s kind of unwind these five questions to ask because we’re trying to solve this sequence-of-return-risk problem, and I think we’ve done it.

The first thing that we do is we ask how much we need in our checking account, which is a function of “How much do we spend each month?” which is a function of “Hey, we need to kind of do a budget here.” 

The second question is, “How much do we need in our emergency fund?” which is 12 times whatever we need in our checking account, supersized emergency fund.

The third question is, “How do we cover our needs with guaranteed income?” We talked about pension, annuity, and social security. [19:02].2]

Number 4: “How do we cover our wants from our investments?” You want to check on that. You want to check your withdrawal rate, which is your annual withdrawal divided by the amount of money that you have in that investment should be around 4%.

Number 5: “How can we leave money as a legacy?”

If you ask those five questions, get answers to those, I think you’re going to find your retirement to be more peaceful. You’re not going to have to worry or be frantic, or wonder, What’s the plan? What are we doing here? I pretty much assure you your financial guy, again, this is kind of I guess a pitch for PAX here, but I’m pretty sure your financial guy is kind of making it up as they go. This is a solid plan, so if they are making it up as they go, guide them, say, “Hey, this is the way I want to do it,” because you do need a solid plan in this chapter of life because the mistakes have zeros on them and, oftentimes, they’re not recoverable.

So, navigate this well. I know you can. Just be thoughtful, considerate, and be sure to ask these questions, and just remember that the problem we’re trying to solve is sequence-of-return risk and then we can not worry about money necessarily, but focus in on our people and making memories in this next chapter of life. [20:05].1]

So, there you go. Hope you enjoyed it. Again, thanks for tuning in. Thanks for you all’s feedback as you continue to communicate what you want to hear, what you like, what you don’t like. darryl@paxfg.com. I love hearing from you guys and it helps put together the content for upcoming shows.

In the meantime, you guys have a great day, and remember, you think different when you think long term.


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