As you approach the withdrawal phase of your financial life (what we used to call "retirement" but now prefer "work optional lifestyle") imagine this:
- You are diversified in your portfolio allocation but still had a fair amount of equity (stock) exposure.
- You have amassed $1 million and seek to take $60,000 per year with a 3% inflationary increase each year and the money is expected to last 25 years.
Three example scenarios are run - one with a flat 7% rate of return (which is obviously impossible and we will discard for the purposes of this post), and two others. The two other scenarios have the same rates of return each year, the sole difference being that the rates of return are flipped. For example, two bad years of returns start in one illustration while the other starts with two positive years.
It bears saying again: the rates of return are numerically the same across both examples.
One portfolio ends up in this example with about the same amount of money as it started with - just north of $1 million. Obviously a million dollars 25 years in the future is worth much less than a million dollars now, but this is showing more optimal spending as a primary goal rather than wealth preservation. (In other words, 6% is a very aggressive withdrawal rate if your main goal is to preserve principal).
The other portfolio ran out of money at year 23.
It is possible that your retirement could be sunk merely by an unlucky couple of years in the beginning.
As financial advisors, accepting and knowing that luck is actually a factor in our success, how do we help defense against sequence of return risk?
- Be more realistic in our withdrawal rate. In the above example, 6% was a quite aggressive withdrawal rate. Commonly, we use between a 4% and 5% withdrawal rate depending on current age and life expectancy to better buffer against down markets. Here's a study on the feasibility of a 4% withdrawal rate.
- Be more flexible in our asset allocation. Continually rebalancing assets as we make withdrawals. If we see a 20% decline in stocks we should consider taking the majority of our withdrawals from asset classes that have positive (or less negative) performance. Note that if we attempt to do this, the investor has to be willing to accept that they will be taking on more risk in this scenario while we wait for stocks to recover. This may test the intestinal fortitude of an investor but also give a better fighting chance once equities do recover (assuming that they will!)
- Be more flexible in withdrawals amounts. In our example, the withdrawal rate was fixed on a dollar amount - $60,000 with inflationary raises. In a down market, this is more dangerous since shares are sold at a loss and removed from the portfolio. In loss environments, removing the shares assures that they will never recover. An alternative to this is to fix a withdrawal rate to a portfolio - for example, 4.5% of the remaining balance. This will require the investor to be flexible in there income stream and pull back on spending in lean years - but will also give them a raise when the returns are positive. The Retirement Café blog writes a good article exploring this concept.
- Consider more guaranteed income sources. There are some cases where buying annuities may make some sense. Immediate or variable annuities may allow you to lock in some guaranteed income to help mitigate some sequence of return risk. Morningstar wrote a good article about this. Keep in mind that annuities are often pushed on clients and they tend to have high fees and pay commissions to brokers. As these are very complex investments, we highly recommend that you see a fee-only fiduciary if you want to consider these products.
For investors the financial industry has focused too much on hot funds and the investment side of the financial planning equation. Financial advice involves complexities far beyond investment selection, and that is essentially why and when people should consider using trusted professionals in their life.