Monday, September 30, 2013

Sequence of Returns Risk: What's That Mean?

My favorite video logo belongs to Far Field Productions and shows up at the end of episodes of the TV series Bones.

After several posts on the subject of sequence of returns (SOR) risk, it's time to tie this subject up in a nice bundle that a normal person (and by that I mean someone who doesn't play around with Mathematica all afternoon for fun) might understand, and to answer the kid's question.

The first thing to know about SOR risk is that you don't have it unless you try to spend down a portfolio of stocks after your retire. (OK, you have it when you're saving to a 401(k) account, too, but it isn't as damaging and there isn't a lot to be done about it). Fixed annuities aren't exposed to SOR risk, and less volatile portfolios that hold bonds, for example, don't have much. A buy-and-hold stock strategy has none.

Assuming you are (or will) try to spend down a stock portfolio after you retire, the thing that you need to know about SOR risk is that average market returns don't tell you everything you need to know about retirement investing. You also need to know the order those market returns will occur.

Here's an example. Looking again at real S&P 500 market returns from 1871 to 2008 provides 108 rolling 30-year scenarios. If we assume a retiree started each of those periods with a million dollars and withdrew $45,000 every year, he or she would go broke in less than thirty years 9 times (8.33% failure rate).

If we graph annualized market returns for those 108 periods against terminal portfolio values (TPV), we find a correlation of only 0.8. (I say "only" because intuition might tell you that average market returns would explain all of the outcome.)

At the bottom left of the chart, you will see that three periods successfully funded 30 years of retirement while averaging only about 3% market return per year. You will also see a portfolio for the period beginning in 1974 that generated a 6.8% annualized market return and failed. (Both circled in red.)

You can win with a 3% average return and lose with a nearly a 7% average. There's no magic here, it's just that the compound growth rate doesn't contain all the information you need to determine if a sequence of returns will lead to successfully funding retirement. 

Look directly above any market return, like 6.8%, and you will find a huge range of terminal portfolio values that resulted from the same average return (one failed and one reached a TPV of $4.6M).

When you are spending down a volatile stock portfolio after retiring, in many cases the annual return doesn't predict whether or not you will succeed (7% and above always worked in this limited sample of 108 periods). The sequence of those returns has a large impact.

If you insist on funding retirement by spending down a stock portfolio, your spending strategy will be based on a constant percentage of remaining portfolio balance or something else. If it's based on "something else", like a constant-dollar spending strategy, your terminal portfolio value will be exposed to SOR risk and you might go broke before you die. This includes SWR strategies.

If you base withdrawals on a percentage of remaining portfolio value, you are less likely to go broke, but your annual payouts will be variable.

If you choose to implement a Safe Withdrawal Rates or other constant-dollar spending strategy, my advice would be the same as in the old joke about the man who tells his doctor, "It hurts when I do this."

Constant-dollar strategies have been repeatedly shown to underperform. Don't do that.

If your advisor tells you that you can withdraw a constant amount from your portfolio after you retire, regardless of how the market performs, get a second opinion. And a third, if necessary.

I suspect that if it weren't for SWR strategies, sequence of return risk would seldom come up. But, when it results in a retiree going broke in old age, as it does with SWR strategies, it gets more attention. 

Best way to avoid the risk? Don't do that.

If you do base spending on a percentage of remaining portfolio balance, you will have varied annual payouts, but you are far less likely to go broke.

No matter what spending strategy you choose, a huge market loss early in retirement will decimate your retirement finances. You should begin to reduce your stock allocation at about age 55 until about age 75 to something like 20% or 30%.

Having read my last few posts on this topic, it would be reasonable to assume that I would advise retirees to spend down stock portfolios based on a percentage of remaining portfolio balance and not one based on constant-dollar withdrawals. But I don't.

I advise retirees to set aside the capital they need to generate enough income to cover non-discretionary spending in a safe TIPs bond ladder or fixed annuities. Then you will have some certainty that you can pay the bills. If you have cash left over, then invest that amount in stocks. None of the three (fixed annuities, TIPs ladders, or buy-and-hold stock portfolios) are exposed to SOR risk.

If you simply must spend down a stock portfolio, then percentage withdrawals of remaining balance are far less expensive and risky.

But, seriously. Don't do that.

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