One of the key challenges of determining “reasonable” spending in retirement is that, even if the advisor is right about the anticipated long-term returns of the retirement portfolio, there’s a risk that ongoing withdrawals on top of a series of early bad returns will cause the portfolio to be fully depleted before the good returns finally arrive to average out in the long run. As a result, retirees must generally spend less than what expected returns alone would otherwise predict is affordable, to defend against this “sequence of returns” risk.
Yet the caveat is that while a bad sequence of returns coupled with ongoing withdrawals can catastrophically deplete a portfolio too quickly, a good sequence of returns can quickly compound the portfolio so far ahead that substantial excess wealth accrues instead. In fact, because of how long-term returns compound to the upside, favorable sequences of returns actually produce far more excess wealth than unfavorable sequences risk to the downside. For instance, taking a 4% initial withdrawal rate has an equal (10%) likelihood of leaving all the retiree’s principal left over at the end of retirement… or leaving 6X the starting account balance remaining instead.
Which means not only is it important to give at least some consideration to the potential and upside “risk” of getting a favorable sequence of returns, but the asymmetric nature of sequence risk to the upside suggests that simply spending conservatively and adjusting later if a “good” surprise occurs may be too likely to leave dramatic levels of unspent wealth that could have been enjoyed earlier. After all, at a 4% initial withdrawal rate, the odds of nearly depleting the portfolio are equal to the odds of growing it by more than 800%(!), and even at a 5% withdrawal rate, the odds of depleting the portfolio early are equal to the odds of tripling the retiree’s starting principal on top of taking an initial withdrawal rate of 5% with 30 years of annual inflation adjustments.
So what’s the alternative? To plan, in advance, for retirement spending strategies to be more dynamic… at minimum, to have a ratcheting plan in place to lift a low initial spending rate higher if the sequence is favorable (or at least, is not unfavorable), and for those who are willing to be more flexible in their retirement spending, to set guardrails in advance to know both when to cut spending in a bad sequence, and when to lift it higher in a more favorable one.
The bottom line, though, is simply to recognize that sequence of return risk truly cuts both ways, creating both the risk of depleting a portfolio too early with a bad sequence (even if returns do average out in the long run), but also the risk of the retiree waiting to long to fully spend and failing to enjoy the assets and income that turned out to be available because a favorable sequence of returns occurred instead!
source https://www.kitces.com/blog/url-upside-potential-sequence-of-return-risk-in-retirement-median-final-wealth/
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