Financial projections and spreadsheet are useful tools for planning out your financial future. I use them all the time; I even created the one you get for free when you sign up for my newsletter. There’s a common problem with these projections though: they usually assume that you’ll have a constant rate of return – say for example, 5% a year – each year leading up to retirement, and then again each year after that.

Here’s the thing about that: if you’re invested in the stock market, any stock market, your returns don’t work that way; they’re messier. Well, guess what? That messiness – the order in which gains and losses happen, called the sequencing of returns – has an impact on what your nest egg does in retirement.

On Your Way to Retirement

In your working years, you’re not touching your retirement nest egg (at least you better not be – what have I been telling you?!). When this is the case, the sequencing of returns doesn’t matter; you’ll end up with more-or-less the same amount of money in the end, as long as your total return remains the same. Have a look at this chart and graph to see what I mean. It assumes you start with a million bucks saved, and you get an average annual return of 5% a year. See what happens? Your money takes a different path each time, but it gets to the same place in the end.

This is why most people can afford to invest in higher-risk, higher-return assets like stocks when they’re younger. The risk of taking money out in a down market is less of a factor, because those saving for retirement aren’t touching that money along the way.

When you’re ready to retire though, things change a little bit.

Sequencing of Returns in Retirement

When you start drawing an income from your retirement nest egg, the order in which your returns happen can all-of-a-sudden have a pretty massive impact on the size of your nest egg. Let’s take the same example – a million bucks, an average annual return of 5% over 5 years – only this time, we’ll subtract an annual paycheque of $50,000, and see what happens.

See the difference? When you’re taking money out of your savings, the order in which returns happen means you no longer get to the same place every time, even if the average annual return stays the same. So why the heck is that?

It comes back to the sequencing of returns. Put simply, if your nest egg drops in value when you start taking money out, the money you’ve withdrawn doesn’t have a chance to recover when the market does. That means you don’t get to benefit when the market bounces back to the same degree as someone who doesn’t touch their money.

On the flipside, if the market sees huge gains when you first start taking money out, you’ll end up in better shape than you would have with consistent gains.

So how do you defend against this?

Well, there are a few different options (like annuities or asset protection insurance) which I’m not going to get into in this post; you’ll want to talk to a financial planner if you want to learn more about those. I’ll just give you one example of something you could do, which is to withdraw less money in years when the market is down. Does it suck? You betcha. Could it make the difference between you running out of money or not? Absolutely.

Wrapping it Up

I know this is a trickier concept compared to some of the other ones I’ve written about, but it was important to me to write about it because I think it’s something that almost nobody thinks about when it comes to retirement planning.

If you’re using spreadsheets to plan for your financial future, good for you. Since you can’t predict the order in which gains and losses are going to happen though, it might be to your benefit to use a more conservative rate of return in your plans. That way, you’ll be better prepared to handle an unexpected dip in the market, and hey… if you get more than you planned for, that’s just bonus, right?

Anyway, sequencing of returns. Know it, don’t fear it, but plan for it.