Have you ever used an online retirement calculator or fiddled with the one provided in your 401(k) website to see if you’re on track? These tools are convenient and often reassuring, but they might not be telling you the whole story.
What Online Retirement Calculators Do Well
Most retirement calculators ask for the basics: your current portfolio value, a time horizon, and a rate of return assumption. From there, they calculate how much you might have by the time you retire. Some take it a step further, asking for your income and desired replacement percentage, offering a simple “Congratulations, you’re on track!” if you meet their parameters.
While these tools provide a rough estimate, they often overlook a critical aspect of real-life investing: variability of returns and sequence of return risk. Ignoring these factors can jeopardize your retirement security.
The Realities of Market Returns
Investing isn’t a straight line. Markets have good years and bad years, and the order—or sequence—of those returns matters. Let’s break this down with an example.
The Accumulation Phase
Imagine someone invests $500,000, planning to let it grow for 25 years before retirement. We’ll explore three scenarios:
- Straight-Line Returns: The portfolio grows at a steady 9.41% annually, resulting in $4.735 million after 25 years. This is the world of online calculators—simple and optimistic.
- Variable Returns (U.S. Stock Market): Using the actual annual returns of the U.S. Stock Market* from 1999–2023, the average return is still 9.41%. However, the ending portfolio value drops to $3.2 million—a $1.5 million difference due to the variability of returns.
- Switched Sequence: By flipping the order of the U.S. Stock Market* returns (worst years first, best years last), the average return remains 9.41%, and the ending value stays at $3.2 million. For portfolios still in the growth phase, the sequence of returns has little impact.
The Retirement Phase: When Sequence of Returns Really Matters
Now let’s apply these same returns to a retiree’s portfolio, starting with $500,000 and withdrawing $20,000 annually (a 4% withdrawal rate).
- Straight-Line Returns: With a steady 9.41% annual return, the retiree’s withdrawals are sustainable, leaving nearly $3 million after 25 years.
- Variable Returns (U.S. Stock Market): The portfolio weathers market ups and downs, but the retiree still ends up with over double their starting value—a fantastic outcome.
- Switched Sequence: Concentrating the worst returns at the beginning of retirement creates a catastrophic scenario. Despite the same average return of 9.41%, the portfolio depletes entirely by year 10. This is the devastating impact of sequence of return risk when combined with portfolio withdrawals.
The Takeaway: Plan for Variability, Not Perfection
Many Online retirement calculators rely on straight-line assumptions, which are both unrealistic and misleading. To build a robust retirement plan, it’s essential to account for market variability and sequence of return risk.
Key Strategies for Retirement Success:
- Create More Accurate Projections: Incorporate variability into your calculations to reflect the realities of investing.
- Structure Portfolios for Down Markets: Build a portfolio that includes assets designed to weather downturns, giving your riskier investments time to recover.
- Plan for Distribution Flexibility: Have strategies in place to manage withdrawals during market declines to preserve your portfolio’s long-term health.
Looking Ahead
In our next post, we’ll explore how to create more realistic retirement projections and practical ways to structure portfolios to address sequence of return risk. Stay tuned for actionable insights that can help secure your retirement, no matter what the markets bring.
*Russel 3000 is used as the index for the U.S. Stock Market