It’s important in comedy. It’s equally if not more important in retirement. In essence, we’re talking about the timing of your retirement and how much you plan to withdraw from your retirement accounts.
Get the timing right and your money is likely to last over the course of your household’s entire retirement. Get the timing wrong and your money, sorry to be the bearer of bad news again, isn’t going to last over the course of your lifetime.
So says Wade Pfau, a professor of retirement income at The American College. In a recent blog post, Pfau ran some numbers, Monte Carlo simulations, to show the effects of what’s called sequence-of-return risk.
In one case, he showed what would happen to 151 hypothetical investors who work and save the same amount for 30 years and get 30 years of market returns, but who differ only in which 30-year period they worked and saved in a 180-year simulated historical time frame. See an image of the results. Read You Can’t Control When You’re Born… Revisiting Sequence of Returns Risk.
And what he found was this: Those hypothetical investors could expect to build on average a nest egg equal to 10 times their salary, but the outcome ranged from a little less than three times salary to more than 27 times salary. “These are very different outcomes for people who otherwise behaved exactly the same,” Pfau wrote.
There’s a bit of serendipity going here for all us saving for and hoping to live in retirement.
What’s more, Pfau noted that in some cases, the hypothetical investor who retired one year after the one who accumulated 27 times their salary built a nest egg of just 17 times their salary. In other words, there’s a bit of serendipity going here for all us saving for and hoping to live in retirement. And in some cases, investors might miss their chance to reach their savings goal after 30 years, wrote Pfau.
“This is sequence of returns risk,” wrote Pfau. “People are more vulnerable to the returns experienced when their portfolios are larger because a given percentage change has a bigger impact on absolute wealth. A big portfolio drop at the end could possibly wipe out all of the portfolio gains from the first 25 years of one’s career.”
Well, according to Pfau, the same risk exists in retirement, and perhaps even more strongly, if retirees are using a constant inflation-adjusted withdrawal strategy, Pfau wrote. Using Monte Carlo simulations, he showed that for his 151 hypothetical retirees, the actual maximum sustainable withdrawal rates over 30-years ranged anywhere from 1.9% to 10.9% “for reasons beyond one’s control reflected simply by the luck of when they retired.” See image.
So what can you do to mitigate the risk that the market’s sequence of returns don’t wreck your retirement plans?
According to Pfau and others, there’s plenty that you can do, much of which centers on putting in place a constant spending plan and a less risky portfolio.
“Sequence risk is just a subset of risk itself, namely, that which occurs during the first period of retirement,” said William Bernstein, a principal with Efficient Frontiers Advisors and author of author of several books including The Intelligent Asset Allocator, The Four Pillars of Investing, and The Investor’s Manifesto. “And there are two ways to mitigate it.”
Try constant, not inflation-adjusted, spending
First off, consider this: Much of the sequence-of-returns risk in retirement comes, according to financial adviser and blogger Dirk Cotton, from strategies to withdraw a constant inflation-adjusted amount from your nest egg, say 4% per year adjusted for inflation.
So, if you want to reduce the sequence-of-return risk consider withdrawing a constant—not adjusted-for-inflation—percentage from your nest egg. “A lot of research (including some of my own) has now shown that a constant inflation-adjusted spending strategy from a volatile portfolio is just about the most inefficient way to approach retirement,” Pfau wrote. “Someone can’t expect constant spending from volatile portfolio. Those who want upside (and, thus, volatility) should be flexible with their spending and should make adjustments.”
Others agree. “Commit to a constant percent withdrawal, so that you reduce your withdrawals with decreases in the size of the portfolio,” said Bernstein. “If you withdraw 4% of your portfolio every year, you may see your dollar withdrawals fall, but you’ll obviously never run out of money.”
Now if you insist on spending down a volatile portfolio, a stock portfolio, consider this approach: “My advice would be to spend amounts that are a proportion of your remaining portfolio balance at any given time,” said Cotton, the owner of JDC Planning, and author of the Retirement Café blog. “That will shift sequence-of-return risk from terminal portfolio balance to annual payouts, where it will do less harm.” Read Clarifying Sequence of Returns Risk (Part 2, with Pictures!)
By the way, one risk of using an inflation-adjusted withdrawal strategy with a risky portfolio is that you run the risk of lowering your desired standard of living at some point during retirement. And you might not want to do that.
De-risk your portfolio
Sequence-of-returns risk is a function of volatility. So, Pfau wrote, spending could be kept constant if your portfolio is de-risked. In other words, you can reduce the sequence-of-returns risk by reducing the risk of the portfolio. In other words, said Bernstein, “own less stocks.”
“To really get constant spending, one should be looking to hold fixed-income assets to maturity or use risk-pooling assets such as annuities,” Pfau wrote. “The inefficiencies of a constant spending strategy using volatile assets may be explained because of the added sequence-of-returns risk which offers no reward to investors.”
Others endorse this tactic too. “You can completely eliminate sequence-of-return risk by investing the money you need to spend in retirement in a safe bond ladder or fixed annuities,” said Cotton. “If you’re fortunate enough to have some left over, you can buy and hold stocks with that money.”
Bernstein defines a risk-free portfolio as one adequate for a basic retirement—a so-called liability-matching portfolio. With a liability-matching portfolio, you earmark certain assets to pay for your basic retirement expenses, or liabilities. “Anything in excess of that can be invested in risky assets,” said Bernstein. “For some folks, that’s going to mean a 100% fixed-income portfolio, and for wealthier clients, something far more aggressive.”
Start low, end high
Another approach to reducing the sequence-of-returns risk is to start your retirement with a low percentage of your nest egg in stocks, say 20%, but then gradually increase that percentage to say 40% or 50% over time. Doing this, Pfau wrote, “reduces vulnerability to early retirement stock market declines which cause the most harm to retirees.” Read An Adage Adjustment for Investors at Retirement.
Cotton also recommend reducing your stock allocation in early retirement when sequence-of-returns risk is greatest. “I think we have far greater risk then than we have realized,” said Cotton. “I retired just a few years before the ‘great recession,’ so I have a new perspective on that topic.”
According to Pfau, what happens during the first 10 years of your retirement largely dictates whether you’ll outlive your money. Invest too much in stocks early on, withdraw too much, especially during a bear market, and the next thing you know you know you’re out of money.
Consider a safe savings rate
A final idea is to consider is what Pfau calls his “safe saving rate” approach which focuses on using a consistent savings strategy and eliminates the need to worry about wealth accumulations and withdrawal rates.
This strategy, he wrote, works better if there is a tendency for mean reversion in the markets, which has been observed historically with regard to the cyclically-adjusted price earnings or CAPE ratio, made famous by Robert Shiller of Yale University.
According to Pfau, low sustainable withdrawal rates tend to follow bull markets, and high sustainable withdrawal rates tend to follow bear markets, and by linking pre- and post- retirement together the mean reversion cancels out some of the sequence-of-returns risk. In other words, you might be able to maintain a high withdrawal rate and avoid sequence of return risk provided you do it during certain market conditions.
At the moment, given the current CAPE ratio and current bond yields, the most you could withdraw from your portfolio and not run out of money, according to Pfau, is about 3%.
Like we said, retirement, like comedy, is all about timing.
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