Broker Check

The Four Percent Rule and Sequence Risk

Timing is everything when it comes to building a retirement account, and one of the most important timing factors is sequence risk. What is sequence risk? This investment term is an elaborate way of defining the possibility of the market falling after one is in retirement. Remember: Retirement is the “distribution phase” of investing, as opposed to the “accumulation phase” that one is in while saving for retirement and building a portfolio. Because the retirement account is only useful if it actually distributes income to the retiree, sequence risk is an extremely important factor for everyone building a portfolio to consider.

Now, let’s address how sequence risk relates to the four percent rule: the idea that retirees can withdraw and live on four percent of their retirement accounts every year. We’ll start with an hypothetical example. Let’s say a retiree has a $1,000,000 portfolio when the market is strong, and he has been withdrawing four percent from the account annually; that means the account has distributed a $40,000 income to him every year during that time. (That’s still a pretty fixed income, which is one reason why the four percent rule is no longer practical.) Regardless, we’ll say that is the sequence he is used to. Remember, the four percent rule says that your withdrawal rate starts at four percent and increases with inflation for each year. That means that a person with a $1 million retirement account will withdraw $40,000 the first year, $41,200 the second year, and so on.

Suddenly, there’s a significant market decline. The economy takes an abrupt, steep downturn as it did in 2008 – a time when the average retirement account took a 14% loss. His $1,000,000 is now worth $860,000, because it took a hit of $140,000. He is used to withdrawing four percent every year; it’s what he’s been doing every year since he retired, because his retirement planner used the four percent rule. But now, that four percent rule says that he should be taking $41,200 per year so he can keep up with inflation. That means his account balance is now $818,000. His annual income is now at risk.

Clearly, this is a scenario no retiree wants to be in. So what can one do to help avoid the pitfalls of sequence risk? The first step is to understand that it is a very real possibility. Sequence risk will inevitably happen, because markets are cyclical. Yes, Wall Street is more heavily regulated now – and yes, lending practices have tightened considerably – but that doesn’t mean sequence risk has been eliminated. All kinds of conditions contribute to market cycles, so sequence risk will always be present. More on that in a moment.

The next step to avoiding the dangers of sequence risk is to forget the four percent rule. For one thing, it’s an outdated method; financial planner William P. Bengen created the model in 1994. It also fails to account for the taxes you will pay on your retirement account income – which, recent news suggests, may increase significantly. Finally, the four percent rule does not take into consideration the fact that people are living longer than ever. If the average retirement account holder retires at 65 and withdraws four percent every year, there is a 25 percent chance of him running out of money before he dies. For all these reasons, the four percent rule is no longer practical.

This idea is not new; in a 2010 report in the Journal of Financial Planning, Larry R. Frank, CFP®, and David M. Blanchett, CFP® wrote that retirees can avoid sequence risk by withdrawing less than four percent per year. The article states that the idea of sequence risk being temporary is false; instead, there is a “spectrum” of exposure to sequence risk at all times, depending on certain factors in the portfolio. “Sequence risk is always present,” the writers stated. “While a distribution portfolio’s exposure to sequence risk changes over time, sequence risk never really goes away unless the withdrawal rate is constrained considerably.”

But is it really necessary to live on a “constrained” withdrawal rate? Absolutely not. If you have access to actuarial assets such as life insurance and annuities, it is possible to enjoy a much higher income on a guaranteed basis. That’s what a self-created Personal Pension Formulation is all about. Anyone who wishes to create retirement income streams must realize that sequence risk plus the four percent rule equals a dangerous combination – and they must seek advice from a financial planner that can help them avoid those consequences.

All numeric examples and any individuals shown are hypothetical and were used for explanatory purposes only. Actual results may vary.

Life insurance should be purchased by individuals that have a need to provide a death benefit to protect others with insurable interests in their lives against financial loss. Life insurance is not a retirement plan, investment, or savings account.