Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / The Sequence of Returns Risk That Breaks Early Retirement
Transcript
- Lucas: So we talk a lot about the 4 percent rule, the Trinity study, safe withdrawal rates. But there's this hidden risk that makes all those numbers look shaky, and it's called sequence of returns risk. Luna: Sequence of returns. That's the idea that when you start withdrawing matters more than the average return you get over the whole retirement. Right? Lucas: Exactly. Imagine two retirees who each have a million dollars, and over a 30-year retirement they both earn an average of 6 percent per year. Same average, but one retires into a bull market and the other into a bear market. Their outcomes can be wildly different. Luna: Because the bear market hits early, when the portfolio is biggest and you're making withdrawals. That's the sequence problem. Lucas: Right. Let's run the numbers. Retiree A retires at the start of a market drop. Year one, the market falls 20 percent. They withdraw 4 percent, forty thousand dollars. Now their portfolio is down to seven hundred sixty thousand. Year two, another 10 percent drop. They withdraw another forty thousand. Now they're at about six hundred forty-four thousand. That's a brutal start. Luna: And Retiree B gets the reverse: years one and two are up 20 and 10 percent. So after two years they've got way more than a million, even after withdrawals. Lucas: Exactly. The math says Retiree A could run out of money in about 15 years. Retiree B still has more than they started with after 30. Same average return. Just different order. Luna: That's terrifying. So what do we do about it? It's not like we can choose the sequence. Lucas: You can't control the market, but you can control your withdrawal strategy. A few approaches. First, the cash buffer. Keep one to two years of expenses in cash or very short-term bonds. When the market drops, you spend from that cash instead of selling stocks. You let the stocks recover before you touch them. Luna: That's smart. But how much cash do you really need? Two years feels like a lot. Lucas: It depends on your risk tolerance. The classic study suggested five years of cash for maximum safety, but that drags on returns if the market doesn't drop. More practically, many planners recommend one to two years. The point is to avoid selling into a down market for the first several years. Luna: Okay, but what about the first year of retirement? If you start withdrawing right when the market drops, that cash buffer hasn't been built yet. Lucas: That's why you build the buffer before you retire. Ideally, you have your cash bucket ready at retirement. If you're planning to retire in 2026, start building that cash in 2025. It's a pre-retirement move, not a post-retirement reaction. Luna: So it's part of the retirement plan, not an afterthought. What else? Lucas: Another strategy is flexible withdrawals. Instead of taking a fixed 4 percent, you can tie your withdrawal to market performance. In down years, you cut spending. Maybe you go from forty thousand to thirty thousand. That reduces the damage. Luna: But that requires lifestyle flexibility. Not everyone can just cut their spending by 25 percent overnight. Lucas: True. That's why the cash buffer is more reliable for most people. But there's also the 'guardrails' approach, where you adjust within a range. Say you have a ceiling and floor. If the portfolio drops more than 20 percent, you cut withdrawals by 10 percent. If it's up, you can increase a bit. The key is not to lock yourself into a rigid number. Luna: That sounds reasonable. But let's be honest—most early retirees I know are pretty lean already. They don't have much fat to cut. Lucas: That's a real concern. Sequence of returns risk is especially dangerous for early retirees because they have a longer time horizon. A 30-year retirement is one thing, but a 50-year retirement multiplies the risk. The first few years matter even more. Luna: So maybe the solution is to work a few more years, build a bigger buffer, or have a side hustle during the first decade. That's a common theme. Lucas: Yeah, that's the 'Coast FI' idea we talked about. But let's stick with sequence risk for a moment. There's actually a famous study by David Blanchett from Morningstar. He found that the traditional 4 percent rule fails much more often when you account for sequence risk, especially for early retirees. His data suggested a 2.8 percent to 3.2 percent withdrawal rate for a 50-year retirement. Luna: That's a big difference from the classic 4 percent. So the safe number might be lower than people think. Lucas: It depends on your asset allocation and willingness to adjust. But the core lesson is: don't just calculate your average return. Stress-test your plan with a sequence that mimics 1929 or 2000 or 2008. If your plan fails under those scenarios, you need to build in more protection. Luna: I've heard of the 'bucket strategy'—where you have cash, bonds, and stocks in separate buckets. Spend from cash first, then replenish from bonds when stocks are up. Is that the same as the cash buffer? Lucas: Similar, but the bucket strategy is more systematic. You have a cash bucket for 1-2 years, a bond bucket for years 3-10, and a stock bucket for everything beyond. You refill the cash bucket from the bond bucket when stocks are good, and you never sell stocks in a down market. It's a popular approach. Luna: That would require a pretty big bond allocation though. If you're 60/40 stocks to bonds, that's a lot of fixed income. Lucas: Right, and that lowers your overall return. But for someone who wants to minimize sequence risk, it's a trade-off. There's no free lunch. You either accept lower returns for safety, or you accept the risk and hope for good sequence. Luna: So what do you recommend for our listeners who are planning to retire early? What's the most practical takeaway? Lucas: I'd say: first, run a Monte Carlo simulation that includes sequence risk. Most online retirement calculators do this. Second, build a cash buffer of at least one year of expenses before you retire. Third, be prepared to adjust your withdrawals if the market drops more than 20 percent in your first five years. That's the bare minimum. Luna: And if someone is already retired and didn't do this? Say they retired in 2024 and the market has been kind so far, but they're worried. Lucas: They can start building a cash buffer now by cutting spending or earning some income. Even a few months of expenses as cash makes a difference. They can also consider a part-time job or side gig to reduce withdrawals. It's never too late to derisk. Luna: That's reassuring. Also, if our money conversations have helped you think about a decision differently, we have a listener-supported model that keeps this podcast ad-free. If you find value here, you can buy me a coffee dot com slash fexingo. It helps us keep producing episodes like this one. Lucas: Yeah, and we really appreciate that. It allows us to focus on the details without any sponsors. So back to sequence risk—let's look at a concrete example. Take someone retiring in 2000 with a million-dollar portfolio, 60/40 allocation, withdrawing 4 percent. By 2003, after the dot-com crash, their portfolio would have dropped to about six hundred fifty thousand. They'd be in serious trouble. Luna: And if they had a cash buffer of two years, they could have avoided selling stocks at the bottom. They'd have spent cash instead, and by 2003 the market was recovering. Lucas: Exactly. The cash buffer doesn't prevent the market from dropping, but it prevents you from locking in losses. That's the whole point. And for early retirees, those first five years are critical. Research by Wade Pfau shows that the withdrawal rate that works for a 30-year retirement often fails for a 50-year retirement because of sequence risk. Luna: So the takeaway is: plan for the worst sequence, not the average. And have flexibility. Lucas: Exactly. I'd rather have a plan that survives a bad sequence than one that maximizes spending in a good one. Because you can't predict the order. Luna: And that's the kind of pragmatic thinking that makes early retirement sustainable. Thanks, Lucas. Lucas: Thanks, Luna. That's all for today. We'll be back with more on the numbers that matter.