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Michael Kitces

Retirement Planning > Spending in Retirement > Income Planning

Kitces: Making Retirement Portfolios Last by Managing a Key Risk

By Dinah Wisenberg Brin

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What You Need to Know

  • Returns in the first retirement decade matter more than in the first year alone, the planning strategist says.
  • An initial 10-year period with bad returns can dig a deep hole for clients, he notes.
  • A good opening sequence should result in excess returns, he says, even if there's a crash after 30 years.

Clients nearing retirement and worried they might outlive their savings may focus on what will happen if the stock market crashes as soon as they leave the workforce. 

What the market does the year someone retires, however, is less important than how it performs over the next decade, according to Michael Kitces, chief financial planning nerd at Kitces.com and head of planning strategy at Buckingham Wealth Management.

Slow market recoveries or extended stretches with low returns can have a magnified effect on retiree wealth over time, and volatility plays a role as well, he said last month at Charles Schwab’s Impact 2023 conference, where he discussed sequence of returns risk.

The sequence of market returns matters greatly and can cut both ways, Kitces told advisors. A good first decade will allow investors to “blast so far ahead” that a major downturn late in their retirement “is basically just a speed bump” on the way to octupling assets after 30 years. 

With a bad first decade, however, “you can dig a hole so deep you can’t recover,” Kitces said, noting that the inflation rate makes a big difference as well.

Two clients with the same $1 million portfolios and the same 10% average stock returns over 30 years, both with 5% bond returns, won’t have anywhere near the same outcomes if the sequences of stock market returns are flipped, Kitces explained.

In other words, a client will have significantly different results if the stock market returns 0% in the first two years and 20% in the last compared with the outcome for a client who experiences a stock market with a 20% return in the first two years and 0% in the last — even though the market returns average 10% for both over 30 years.

The client with 20% stock returns in the first two years will never have to touch the principal; if there’s a downturn at the end, the client will just end up with less excess wealth than if there hadn’t been, Kitces noted. 

The client who experienced 0% returns in the first two years, in contrast, will quickly have to chip into principal and likely run out of funds before the 30 years have passed, never getting the chance to catch up and experience any big market gains in the last two years, he explained.

As for inflation’s effect, Kitces said, “Plus or minus half a percent inflation is a nine-year swing on the survival rate for a 30-year portfolio.”

Citing the 30 years from 1969 through 1999, Kitces said, “by any measure this was an absolutely amazing time to be an investor,” with the average portfolio returning 11.5%. Inflation ran at 5.3%, he said.

In theory, given the market returns, an investor could safely withdraw 7.4%, or about $74,000, in those years. Given inflation, however, “you’re flat broke in 12 years,” Kitces said, adding that the $74,000 lifestyle grows to nearly $350,000 by the end due to inflation. 

“It doesn’t matter if you get returns in the long run when you don’t have enough money left,” Kitces said.

So how do advisors help clients defend against “sequence of return” risk? 

Safe withdrawal rates, dynamic asset allocations and dynamic spending strategies can help manage the risk, Kitces said. A key message: Conservative withdrawal rates in the early retirement years can significantly improve long-term results.

Safe Initial Withdrawal Rates

The much-discussed guideline recommending a 4% initial withdrawal rate was taken from research looking at what it would take for a portfolio to withstand the worst 30-year sequences of returns in market history.

That research, covering retirements starting in the years 1871 to 1982, shows 4% as a safe rate for the worst year, 1966, after which the stock market showed no appreciation for 15 years, Kitces said. 

Assume a new retiree has a $1 million portfolio balance with a 4% initial withdrawal rate — a $40,000 spending withdrawal in the first year. After that, the retiree never looks at the percentage again and simply withdraws $40,000 a year, adjusting the amount for each year’s inflation, he explained in an email.

So the client would spend $41,322, or whatever the inflation adjustment would be, and so on for each subsequent year.

Looking at historic returns, a 1966 retirement saw the only 30-year sequence in which starting with $40,000, and adjusting spending for each year of actual inflation — while the portfolio moved up and down with stock and bond returns — resulted in the person spending down a retirement nest egg over the 30 years, according to Kitces.

“For which they still made it to the end without running out along the way, but only just made it to the end and had nothing left at the end of the 30th year. So anything more than that 4% initial withdrawal rate, and they would have actually fallen short,” he explained.

It’s usually unnecessary to be that conservative, although retirees do it anyway just in case, he noted to the Schwab conference audience. Many retirees using the 4% initial withdrawal rate quadrupled their wealth over 30 years, he said.

The basic strategy calls for spending low enough so that if investors encounter the worst possible return sequence, like those retiring in 1966, they’ll be all right and can adjust if the sequence is good, Kitces said.

Dynamic Asset Allocation

Dynamic asset allocation can take several forms, including bucket strategies, Kitces said. The simplest bucket strategy looks at the investor’s near-term, intermediate-term and long-term spending needs, he explained.

The assets needed in the near term (three years) would be placed in cash or cash equivalents, representing about 12% to 15% of the portfolio. Intermediate-term assets representing about 35% of the portfolio would go into bonds, while funds needed in the last 20 years of retirement, about half the portfolio, would be in stocks.

It’s not that different from what most investors would consider a diversified portfolio, Kitces said.

There are different ways to construct buckets, he said, noting annuities, for instance, can provide an alternative to the traditional bucket strategy. Social Security benefits and an immediate annuity could cover essential expenses throughout retirement, with portfolio withdrawals covering discretionary spending and increasing over the retirement years, according to Kitces.

Advisors secure the essentials bucket with guaranteed income.

“The whole point here is you cannot outlive your essential expenses,” the planning strategist said.

If bad things happen in the portfolio and the client faces an awful returns sequence, only discretionary spending is at risk and essential expenses — food, clothing and shelter — are covered.

Other strategies include a valuation-based asset allocation approach, in which the retiree maintains a mid-range stock allocation and adjusts it when markets are overvalued or undervalued, and a “rising equity glidepath” that, contrary to conventional wisdom, boosts equity allocations throughout retirement.

Research shows that increasing the equity allocation over the years helps with retirement income, Kitces said.

Looking at stock market price-to-earnings ratios when retirement starts can help predict safe withdrawal rates, since P/E ratios highly correlate to 15-year returns, which in turn can usually predict a 30-year safe withdrawal rate, Kitces also explained. (He referred specifically to the P/E 10, which divides stock price by average earnings for the past 10 years, adjusted for inflation.)

Managing the sequence of return risks matters more in environments like the current one, with high valuations implying that 15-year returns will be below average and withdrawal rates more restrained, Kitces said.

Dynamic Spending Strategies

Dynamic spending strategies include ratcheted spending, which has retirees starting with a safe withdrawal rate and bumping up spending when they get ahead so they don’t end up with excess money 30 years in that they could have used earlier.

So if the portfolio is up more than 50% from its starting balance because the retirees built a good cushion, for example, they can give themselves a bonus 10% raise every three years, Kitces said. (Someone who retired in 1966 would never reach this point, he noted.)

Some people use ratcheting strategies that only move up, while others adjust up or down, using “bumpers” with floors and ceilings on withdrawal rates, depending on what happens in the markets, Kitces said. This might be a 5% initial withdrawal rate, with a 6% ceiling and a 4% floor as guardrails.

“Different advisors will do this different ways,” with different preferences based on their styles, he noted. Some mix and match strategies, combining buckets and bumpers, for example.  “To each their own.”

Some firms craft their strategies into a withdrawal policy statement, Kitces said. This document could detail income goals, available assets, initial withdrawal rate, liquidation and sourcing methods (interest, dividends, capital gains and account types) and adjustment triggers.

Pictured: Michael Kitces

Dinah Wisenberg Brin

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