The Household Balance Sheet

The household balance sheet is one of many topics I've never quite gotten around to, but New Jersey retirement planner Michael Lonier recently offered to write a guest post and he has provided an outstanding introduction to the topic. Please check out Mike's impressive bio, too.

Enjoy!

Finding the Upside on the Household Balance Sheet

Inescapably the time comes to consider that spending from savings is different from saving from income. You survey your savings and investments, scattered across a number of accounts, and the question arises, how best to manage this money to get the best lifetime outcome for the household when you are no longer earning a high income from full-time employment?

Maybe you’re thinking about rolling over 20 or 30 years of 401(k) contributions made to an assortment of funds almost randomly picked over the years, or are holding mostly cash after exiting the market during the 2008 crisis and now realize your money needs to work harder.

How do you organize—allocate—your savings and investments? How much should you invest in stocks and bonds and keep in cash? How do you decide what is best for you?

The Answer to the Puzzle is More Puzzles

You can go with rules of the thumb, like the old chestnut “age in bonds,” possibly with +/- some number adding a veneer of math to what is essentially an arbitrary amount. You can put your money in a target date fund and pay a fund company .20% to 1.00% to use their proprietary “glide path,” which adds a costly layer of research to the age in bonds formula. (Hint: Index TDFs are cheaper.) Dig deep enough, and your head might spin over how highly researched glide paths can be so different.

You can ask an investment advisor who will give you a short quiz and categorize you as conservative, moderately conservative, moderate, moderately aggressive, or aggressive, and plug you into a model portfolio that has somehow been matched with these categories which have somehow been matched to the quiz answers you gave. If that doesn’t seem right, there are advisors who will give you a longer quiz, or more categories, like south-by-south-west, or both. And whichever direction you turn, you’ll pay maybe 1.00% a year.

Everyone has an answer to your puzzle. It’s just that they’re different answers.

If you want to figure it out yourself, you are encouraged by most experts to think deeply about your risk tolerance, how you are likely to react when the bottom falls out, how much you can afford to lose (none!), and then pick a number between 0% and 100% for stocks based on…your best guess.

Look Beyond Your Investments to Your Balance Sheet

Your savings and investments are just one part of the puzzle, one part of the resources you need to manage to get the best outcome. You need to start at a place that accounts for all of your resources, that balances what you have and what you need, revealing the weaknesses—the risk exposures—you need to overcome. Financially, the place to start is with your household balance sheet.

You are probably familiar with a simple net worth statement that sums up current financial assets and debts and provides a snapshot of solvency. A full household balance sheet for planning goes further than that. The asset side of the balance sheet includes the current value of savings and investments (financial capital), the discounted present value of expected future earnings (human capital), and the discounted present value of expected Social Security benefits and pensions (social capital). The liability side includes the discounted present value of all expected future expenses, including debt service and payoffs.

I won’t cover the details of how to calculate these present values in this post, but though it sounds intensely complicated, it’s not. It’s within the reach of anyone familiar with using Excel, and is no more involved than examining your conscious for risk and divining an asset allocation from an arbitrary formula. More importantly, it represents your specific household situation in a logical and mathematical fashion without making any leaps of faith about theoretical risk, personal inclinations, or market behavior. More math, less magic.

Let’s look at a household balance sheet constructed in this way (below). What does it tell us?

The assets on the left include $1,824,700 of financial capital (FC), which is the current value of the household savings and investments in retirement and taxable accounts. The relatively low $274,800 of human capital (HC) suggests in this instance a household nearing retirement with just a couple years of earnings remaining. Someone with ten or fifteen years of employment ahead of them might have human capital over a million dollars. Not surprisingly, the $1,977,000 present value of social capital (SC)—Social Security and pension benefits over a 30-year retirement plan—is the most valuable asset on this particular household balance sheet.

On the liability side, the present value of all expected future expenses over the life if the plan (about 33 years in this case) is shown as $3,381,400. Subtracting liabilities from assets, the balance sheet shows a cushion or surplus of $695,200.

The financial lifecycle is the process of converting human capital into a stream of income that covers ongoing current expenses while building FC and SC to cover future expenses when HC has been “spent down” going into retirement. The balance sheet shows the current relationships between savings and investments, expected future earnings, accrued social capital benefits, and expected future expenses, all either in current or discounted to current dollars. It is the definitive household financial lifecycle scorecard, and so is enormously useful in answering the question about how best to allocate household resources.

Some simple math allows us to focus on the puzzle of puzzles, the allocation of financial capital (below).

If we subtract the sum of HC and SC ($2,251,900) from liabilities ($3,381,400), we are left with $1,129,400, the amount of expenses that must be covered from savings and investments (from FC). We can call this amount ($1,129,400) the income floor, the minimum amount of FC needed to cover expected expenses. Note that the cushion of $695,200 from the balance sheet is the amount of FC above the floor (FC of 1,824,700 minus floor of 1,129,400 = 695,200 cushion). This represents, after holding back some amount for reserves, the risk capacity indicated by the balance sheet, or more simply, the upside. In this case, after holding back a reserve of $125,100 from the cushion of $695,200, the resulting upside is $570,100.

The final step is to lay this out as an allocation of financial capital, based solely on the strength of the household balance sheet (below).

Using the amounts above, the balance sheet shows an Upside/Floor/Longevity/Reserves allocation of 31.2%/61.9%/0%/6.9% (Longevity is a discussion for another day, but it generally starts with funding the deferral of SS benefits as the best deal around). Note that although this shows how much of FC can be exposed to upside risk and how much should be managed as floor, it is agnostic about how that should be done. In fact, as shown above under the “Adjusted” allocation, once you know what your balance sheet says, you can make an informed decision to expose more floor or less upside to risk, as you determine works best for you. In this case, about 9% of the floor has been allocated to upside (increasing the balance sheet upside allocation from 31.2% to an adjusted 40%), putting that much of the floor at risk—and therefore requiring careful management to prevent market losses from damaging the ability of the floor to cover expenses.

The Foundation for Solving the Puzzle

There is a misapprehension that using balance sheet risk management to allocate financial capital is somehow insurance product centric, puts safety-first above all, or is just liability matching in a different costume. It can be used to allocate any of those things, just as it can also be used to allocate a total return portfolio, a dedicated floor with upside, a bucket system, or a combination of upside portfolio, bond ladder, and insured products. All of those things are about implementation, and are independent of the mathematical determination of how much household FC should be managed as upside, floor, longevity, and held for reserve.

Balance sheet analysis comes before implementation. It replaces the narrow view of the investment portfolio and total-return allocation theories as the central focus of retirement with a broader understanding of the overall household financial situation and managing all the risks that can affect the retirement plan, not just investment risk.

The household balance sheet, not portfolio theory, is the foundation of personal financial management, anywhere in the lifecycle. A solid understanding of the household balance sheet provides the basis for a reasonable and practical way to solve the puzzle of how to best use household resources to fund retirement or reach other goals.

This is a brief introduction to a subject with a deep body of knowledge that is typically not part of an investment advisor’s agenda. For more information, check the reading list at the Retirement Income Industry Association website for links to additional readings and sources.

--Michael Lonier, RMA^®

Are Social Security Benefits a Bond?

Jack Bogle has suggested in the past that Social Security benefits are like a bond and should be treated as such in his “age in bonds’ allocation strategy. His reasoning is, I believe, that having that safe stream of income allows you to take more risk by buying more stocks with the rest of your investments, and it does.

Whether or not you should buy more stocks, of course, depends on your risk capacity, risk tolerance and current wealth and spending, and not simply on your age. Just because you can buy more stocks doesn't mean that you should. I also agree that a retirement income plan should consider all of a household’s assets, including Social Security benefits.

I draw a line, however, at including the present value of Social Security benefits into the bond portion of an upside portfolio to calculate my asset allocation. That’s why I recommended considering Social Security benefits as a component of the floor portfolio in Three Portfolios and calculating the asset allocation of the risky portfolio separately.

(There is a good discussion on this topic — there usually is — in the Bogleheads forum. You will notice that most posters, despite being members of a forum devoted to the philosophies of Jack Bogle, as am I, aren't really on-board with his position in this case.) 

There are several ways in which Social Security benefits are not like a bond, and therein lies the problem.

First, we can't buy or sell Social Security benefits. If we include them in our asset allocation, we can't rebalance that allocation.

Second, for most American households, the present value of Social Security benefits is the largest component of the household's wealth, followed by home equity and then retirement savings. Treating the present value of Social Security as a bond would force most households to invest their entire savings in stocks and still not be able to achieve a reasonable asset allocation.

(The present value of Social Security benefits can be estimated by getting a quote for a life annuity from an insurance company with payouts equal to expected Social Security benefits. In today's interest rate environment, multiplying your expected annual benefits at retirement age by 20 will put you in the ballpark of their present value. For a more accurate valuation, I like Income Solutions at Vanguard.com for a quick online quote.)

Third, and perhaps most importantly, few retirees will value the present value of Social Security benefits as highly as they value an equal amount of stocks and actual bonds at the margin. They might (should) like the benefits better for a large portion of their wealth, but be unwilling to convert all of their stocks and bonds to illiquid Social Security benefits.

Retirees have expressed this preference by refusing to annuitize all of their retirement savings. It's a nearly identical scenario, given that Social Security benefits are an annuity. It stands to reason that they would be equally reluctant to back into an all-annuity position by risking the loss of much of their liquid portfolio.

Stocks and real bonds can be converted to cash to meet emergencies, to spend more in some years than others, or to take advantage of investment opportunities. If you need more money from Social Security benefits, all you can do is wait. Consequently, retirees with most of their wealth in the present value of Social Security benefits should be inclined to take less risk with their relatively small portfolio of stocks and bonds, certainly less risk than a 100%-stock portfolio would entail.

Social Security benefits reduce risk no matter how you treat them in an asset allocation because they reduce spending from a risky portfolio. The probability of a systematic withdrawals portfolio surviving decreases with more spending. Reduce spending from that risky portfolio by spending Social Security benefits, instead, and you can significantly extend the life of your savings.

In fact, reducing spending is usually a more effective way of reducing risk than is adding bonds to your portfolio. As William Bengen's chart below shows (focus on the 30-year line), unless you currently hold more than 70% stocks, adding more bonds doesn't change the SWR rate much. (If the sustainable withdrawal rate decreases, it is because SOR risk has increased, and vice versa, so a falling curve indicates more risk.) Adding bonds below a 30% stock allocation actually worsens risk.

Treating benefits as a bond in the asset allocation requires the purchase of more equities to obtain a desired asset allocation and thereby increases risk.

Here is an example of the two alternatives, considering the present value of Social Security benefits as a bond in the asset allocation as shown in the top chart below, and omitting them from that calculation in the bottom chart.

Assume a household has $250,000 saved in a 401(k). They expect $30,000 a year from Social Security benefits and can buy a similar life annuity today from an insurance company for $600,000. The household might consider their Social Security benefits, then, to be a bond worth $600,000. Let’s further assume that the household would prefer a 50% bond portfolio because they wouldn’t be comfortable with more than a 20% loss of their savings ($50,000) in a bear market crash.

The riskiest portfolio allocation this family can implement for their savings, when considering their benefits a bond, is obtained by investing all $250,000 in stocks. Doing so would still only create a 29% equity portfolio ($250,000 / $850,000), but a 100%-stock upside portfolio. They would have lost over 50% of their cash and bond value ($125,000) in the 2007-2009 market crash and 100% equities is well beyond what Bengen found to be optimal for systematic withdrawals.

Had they ignored Social Security benefits for asset allocation purposes, alternatively, they would hold $125,000 in stocks, $125,000 in bonds and would have lost about 20% of that, or $50,000, in 2007-2009.

How would income be affected in these two scenarios? In both scenarios, the retiree could spend $30,000 a year from Social Security benefits. 

In the Social Security bond scenario of the upper chart, again according to Bengen, the systematic withdrawal rate for a 100% equity portfolio would be about 3.6% of $250,000, or $9,000. That would support total annual spending of just $39,000 a year.

In the scenario without a "Social Security bond", represented by the bottom pie chart, he could spend a systematic amount from the risky portfolio of about 4.4%, according to Bengen, with a 50% equity allocation of the spending portfolio, or $11,000, for total spending of $41,000 annually.

If your are so fortunate that the present value of your Social Security benefits is a small portion of your household wealth, which is to say you are quite wealthy, treating Social Security benefits as a bond in the asset allocation will make little difference. But most American households aren't wealthy.

I recommend that you calculate your asset allocation both ways. If you’re comfortable with the equity allocation this forces on your upside portfolio, then consider Social Security benefits a bond for asset allocation purposes. If doing so would leave you with an unacceptably high equity allocation inside your upside portfolio, then consider the benefits part of your floor portfolio and manage the upside portfolio separately.

I don’t see an advantage to the Bogle suggestion. It increases risk by increasing your equity allocation. Benefits reduce SOR risk by decreasing spending from your risk portfolio no matter how you consider them in your asset allocation. The present value of your benefits can’t be rebalanced and doesn’t have the liquidity of stocks and real bonds. Total spending is decreased when you consider Social Security benefits a bond because the SWR component of income is reduced by the excessive equity allocation of the spending portfolio, from 4.4% to 3.6% of the upside portfolio in this example.

Placing the benefits in your floor portfolio and ignoring them when calculating your risky portfolio’s equity allocation, as I suggested in Three Portfolios, provides a lot more control of your savings portfolio and, in most cases, exposes you to less risk with more spending.

So, in this case I suggest you take the easy route. Consider your Social Security benefits a safe source of income and address your spending needs net of those benefits separately.


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P.S. The Yin and Yang of Retirement Income Philosophies, new from Wade Pfau's blog is great stuff!

RIIA Webinar -- Sequence of Returns Risk

Powerpoint slides for the Retirement Income Industry Association webinar that I presented November 5, 2014 on Sequence of Returns Risk can be downloaded here. RIIA will soon post the video of the presentation and I will provide a link to it from this page as soon as it is available.

Whether you attended the webinar or viewed it later, please post any questions in the comments section below.

Following are responses to questions that were sent to RIIA.

Q: But the risk to a saver in the sense of IMPACT to portfolio is higher nearer retirement because the value of the portfolio is typically at highest point

A: True. As I mentioned in the webinar, a typical retiree will make the largest bets at the end of saving and the beginning of spending. That’s why it’s important to lower your equity allocation during those times to place smaller bets on stocks. Sorry if that wasn’t clear. I tried to circle both areas of the graph with my cursor.

Q: Aren't portfolios in accumulation less susceptible to the order of returns as long as you rebalance into relatively underperforming assets over time...and are passive as well?

Good question! Rebalancing seems to help, at least based on historical data, in both saving and spending stages. Using the RetireEarly Homepage model, rebalancing improved a 91% failure rate to 95% with 4.7% spending in the past. But, most SWR studies rebalance, including Bengen’s original work, so the spending rates you see are probably based on rebalanced portfolios already. Not rebalancing would probably make sustainable spending rates a little smaller.

Q: Talk about bond ladders of zeros as a strategy in retirement please

A: TIPS Bond Ladders are an attempt to build a better personal annuity in a safer way than SWR, which attempts it with stocks. Treasury ladders have no credit default risk, while annuities are subject to the financial strength of the insurance company. Annuities have no residual value after you and your spouse die (there are some protection features available at a cost), but your heirs can receive any unspent TIPS bonds left in the ladder. You can’t really build your own annuity either way, since annuities pool longevity risk. You can build a 30-year TIPS Bond ladder if you can afford it, but if you live 35 years, an annuity will still provide income.

If you search my blog at The Retirement Café for TIPS Bond Ladders, you will find several posts with more information (here, for example.). I plan to write on the topic again soon, so please check back.

I would say that the major problem with TIPS Bond ladders today is their high cost, given historically low interest rates (the same is true of annuities). I’d recommend a 15-year rolling TIPS Bond ladder.

Q: Why is credit/default risk not considered in bond ladders? It was mentioned home loans from the debtor side.

A: It is considered in bond ladders if the bonds aren’t Treasuries. The U.S. government is prohibited by law from defaulting on a Treasury bond. I only recommend Treasury bonds for retirement ladders.

Q: How does this all relate to a risk-adjusted return approach to portfolio allocation? As you noted, different asset types have different returns (and even within bonds)?

A: The chart I showed from Bengen shows the effect of equity allocation on SOR Risk. It doesn’t matter how you arrive at a particular equity allocation. However you arrive at an equity allocation, it appears that you will increase SOR Risk with greater than about 70% equities.

A:  Yes. Spending directly impacts SOR Risk and taxes are more spending.

The impact of inflation on your portfolio depends on the assets you hold. TIPS and Social Security benefits are adjusted for inflation, so there is little impact. Stocks perform poorly when inflation is high, but their returns typically make up for it over the long term. Payments from a pension with no COLA adjustments would be worth less and less over time, requiring you to spend more from your risky portfolio and increasing SOR Risk by increasing spending.

Q: Any comment on Kitces analysis of how SOR risk and inflation periods have played out in history?

A: Only these. Inflation isn’t a problem for the foreseeable future. And future market returns may not look like past returns. There are more good arguments that growth will be slower than there are that it will increase. I wouldn’t bet my standard of living that things will turn out in the future the way they have in the past.

Q: Great presentation!  Followed you right to the end.  

 
A: My favorite question!

Q: It seems like sequence of returns risk is magnified in a retirement where on uses a constant dollar spending approach (Bengen).  Couldn't one solve for sequence of returns by being more flexible with their spending, such as using a constant percentage approach (theoretically never running out of money though spending could potentially decline to a low number at some point)?

A: Yes. I wrote a series at The Retirement Café entitled “Clarifying Sequence of Returns Risk” showing that a constant percentage approach is safer. But as William Sharpe says, “Isn’t it self-evident that your spending should depend on how much money you now have?”

I’ve been retired for 10 years and how much money I used to have when I first retired doesn’t seem to matter to anyone.

Q: Could one lower their sequence of returns risk by beginning retirement with a relatively low SWR level (say, 2.5%) and then slowly increasing the SWR up to the more traditional rate (about 4%) over the course of a few years at the beginning of retirement (say the first 5 years)?

A: Yes. Anything that lowers your spending from a risky portfolio lowers your SOR Risk. Some people can spend less early because they have a part-time job, for example.

Q: GREAT JOB - thanks Dirk I really like your blog!

A: We have a tie for best question!

Q: Professor Stephen Sacks and I have done some work on mitigating the effect of SOR (J. Fin'l Plng Feb 2012) using reverse mortgage credit lines.  Also, Professor John Salter and others have done similar work.  Could you comment on that? Thanks, Barry H. Sacks

A: Without commenting on reverse mortgages, because I have little exposure to them, what I do know is that they would behave much like an annuity, reduce spending from a risky portfolio, and thereby reduce sequence of returns risk.

Webinar on Sequence of Returns Risk, November 5, 2014

I will be hosting a webinar on Sequence of Returns Risk on November 5 for the Retirement Income Industry Association (RIIA). Although the primary audience is financial advisers, the content will be accessible to most do-it-yourselfers and I hope you will join me.

You do need to register in advance, which you can do by clicking here.

Please post any questions you might have in the comments section below.

I previously wrote a series of blog posts on this topic beginning with Clarifying Sequence of Returns Risk, but I hope you will join me for the webinar, too, where I will cover some new ground.

Hope to see you on November 5!

Spherical Cows

Physicists are known for sometimes oversimplifying assumptions in order to simplify the math required to solve a problem. Physicists refer to these assumptions as "Spherical Cows".

The term comes from a story about a farmer who talks to a physicist about his farm's underproduction of milk and asks if the physicist might be able to offer some advice. The physicist goes away to perform some calculations, but soon returns with an answer.

"I have a solution for your problem," he explains to the farmer, "but it only works for spherical cows in a vacuum."

We encounter a lot of Spherical Cows in retirement finance, huge oversimplifications that make the math easier.

For one, we generally assume that market returns are "normally distributed" even though we have tons of evidence that they are not. If they were normally distributed, we wouldn't see nearly as many market crashes as we do. Often we assume they are log-normally distributed, meaning the logarithms of the returns are normally distributed, but they aren't really that, either.

According to Professors Fama and French, "Distributions of daily and monthly stock returns are rather symmetric about their means, but the tails are fatter (i.e., there are more outliers) than would be expected with normal distributions."

They go on to say that longer periods, like years, conform more to a normal distribution. The 23% drop in the Dow of October 19th, 1987 was something that probably never could have happened in a single day under a normal distribution of returns, but the 37% year-long drop in 2008 was a 2.5 sigma event that might happen once every 80 years.

Their advice to investors is to expect more extreme good and bad returns than a normal distribution would seem to indicate.

So, assuming annual returns are normally distributed works fairly well, but not so with daily or monthly returns.

One of my favorite Spherical Cows is the one used to calculate sustainable withdrawal rates. SWR models assume that a mythical investor will continue to spend the same amount of money each year from savings, even after it becomes obvious that he or she is about to deplete their retirement savings. The models take a percentage, say 4%, of initial portfolio value and subtract that fixed dollar amount ($4,000 from a $100,000 portfolio in this case) from the portfolio balance every year, counting the number of years before the portfolio is depleted.

This assumption makes it far easier to build a spreadsheet than would modeling how a real investor might behave with their spending as their savings grow or dwindle.

I don't think most retirees would behave that way. Would you keep spending the same amount if you saw your savings vaporizing before your eyes? I would expect them to spend a little more when their portfolio grows and a little less when it shrinks. Spending 4% of remaining savings each year instead of a flat $4,000 a year might accomplish that, for example.

In an extreme case, say retirement savings shrink by 50% in the first decade after retiring (or, conversely, grow 50%), I suspect a lot of retirees would not only reduce their spending, but abandon the SWR strategy and look for a new adviser. Of course, by then, the retiree has locked in a lower standard of living for the remainder of her life. The life annuity she took a pass on ten years earlier would start to look pretty sweet in retrospect. Despite what you may have read, a shrunken $50,000 portfolio is not assured of doubling in size because the retiree used to have $100,000.

Every retiree will behave differently, of course, and that would be really hard to implement in a spreadsheet or any other software, so we go with the constant dollar spending models because the oversimplified model makes the math a whole lot easier.

Many financial writers argue that no one really "does it that way", meaning everyone adjusts spending based on their remaining portfolio balance instead of spending a flat amount, but I have two responses to that. If no one does it that way, then everyone in the financial press should stop saying that you can do it that way.

And second, the SWR models predict outcomes for you only if you do "do it that way". (Operations Research guys say that a model is predictive only to the extent that its policies are followed.) The SWR results aren't predictive if you do something else, like adjust spending to portfolio value changes – which apparently is what everyone is actually doing.

(In simpler terms, you can't predict the average height of American men by measuring the height of players in the NBA. That's called the unrepresentative sample fallacy. Likewise, you can't predict portfolio failure rates for people who care about their savings balance from the failure rates of mythical retirees who ignore pending ruin.)

SWR predictions work, but only for spherical cows in a vacuum, or retirees who are oblivious to their current savings balance.

Perhaps the biggest assumption we make to simplify the math is that future stock market returns will look like historical returns.

The argument that they will look similar is an inductive argument that is not strong. Inductive arguments can't prove something is true, they can only argue that something is probably true. They are also defeasible, meaning that future information can prove the conclusion wrong. As Nassem Taleb would say, it was accepted as fact that all swans were white until someone found a black one. Future market returns will mirror past market returns until they don't.

It is interesting that some authors choose various periods of U.S. historical market data upon which to base their studies instead of using it all. They say things like, "We used historical data for the post-World War II era, because market data prior to that period is not representative of the current era." If one past period of history was not representative of this one, how do we know that the author's chosen data is representative of the future era, which is, after all, the one we need to know about?

It does make the math easier, though, when we toss in that little assumption.

On the other hand, there are many strong arguments that the future won't look like the past. Wade Pfau showed that 4% sustainable withdrawals only worked in 4 of 17 developed market nations (Canada, Sweden, Denmark and the U.S., in that order), lending credence to the argument that high equity returns in the 20th Century may be an anomaly of American history not to be repeated. Wade also recently argued effectively that future safe spending rates will be closer to 3% than 4% because the current risk-free rate in the U.S. is so low. That means that both stock and bond returns will be lower in the future than they have been.

Is it safe to assume that the worst thirty-year period of stock returns in our limited history is the worst that will ever happen? Well, no, because a black swan could reset the bottom. The bottom was reset in October 1929, for example.

The 30-year period beginning in 1966 was rough on retirees, but 2007 through 2009 were bad years and their returns are currently showing up only at the end of 30-year periods, like 1979 through 2008. With sequence of returns risk, however, we know that the real damage from these years will show up in studies that begin, not end, around 2008. That will be in 2037 and, again, that's the period recent retirees should wonder about.

But it certainly makes the math easier when we assume that we have already seen the worst.

I'm not saying that the work based on these Spherical Cows is without value, because sometimes having a questionable forecast is better than having none. Sometimes, it's the best we can do, given the shortage of reliable fortune tellers. As a friend of mine is fond of saying, "Bad breath is better than no breath at all."

But I also think it's important to understand the strength of the arguments and the assumptions upon which our plans are based. Assuming you're safe because your portfolio would have survived the worst bear market in the past 50 years is a big assumption.

RIAA – Think Like a Pig

I spoke at the Retirement Income Industry Association Fall Conference in Charlotte yesterday. The title of my presentation was "Think Like a Pig" and the topic was how both the math and the mindset of retirees change after we leave the workforce.

I promised to provide a link to my PowerPoint slides on my blog today and here it is. The floor is always open for questions, whether you attended or not.

I thank RIIA for inviting me. I love public speaking. (And private speaking. And I sometimes talk in my sleep because there isn't enough time in a day to say everything I want to say.)

A few of the advisers at the conference admitted they were there because, given the title, they thought I would talk about barbecue.  I hate to disappoint, so here you go. My wife and I had dinner at Woodmill Smokehouse in Charlotte. It was outstanding.

A Geek in Manhattan

I joined Joe Tomlinson and Wade Pfau in Manhattan this past week for a panel discussion about turning assets into income after retirement. The panel was hosted by MarketWatch's Bob Powell. The video will appear on the MarketWatch website in due course.

If you are not reading these three, then you need to start. I’ve linked their names to their websites.

Heck, Nobel Laureate, William Sharpe mentioned in Advisor Perspectives that he reads Wade’s blog. I think that's a big deal. They don’t call it the “Sharpe” ratio because its pointed, you know, and then there's the Capital Asset Pricing Model. Bill has a blog, too. (And, yes, Wade reads it.)

On Wednesday evening, Joe, Wade and I sat up until well after midnight in the Algonquin Hotel lobby talking about TIPS bond ladders. (I know, right?) Wade referred to this as our own "Algonquin Roundtable." I knew Dorothy Parker frequented the hotel and that James Thurber lived there for a while, but the Roundtable was a fun piece of history to learn. My wife and I stayed there several years ago, hoping some of the "literary cool" would rub off.

The conversation was so much fun for me that I lost track of time and I swear I wouldn’t have noticed if Derek Jeter had walked into the lobby. I learned three things.

First, as you can see with the Jeter thing, I tend to exaggerate a little to make a point.

Second, I am a total geek. This was one of the most enjoyable things I've done in a while. (I am undoubtedly the only person who knows me that wasn’t already aware of that. Becoming so excited when my son gave me Mathematica should have tipped me off. My high school yearbook holds a lot of hints, as well.)

And third, while the three of us have interesting disagreements, they are largely on the fringe. On the important things, we are in complete agreement.

I mentioned during the panel discussion that I am not a huge fan of annuities, in part to bait Joe and Wade into a livelier discussion (Joe bit, Wade just smiled). And while I am not a huge fan of annuities, I am also not a huge fan of sustainable withdrawal strategies. I think we all agree that there is no single great solution to funding a retirement that could last 30 years after funding a working career that could last 40. Working 40 years to pay for 70 is a challenging problem, to say the least.

Joe is a strong advocate for life annuities. I suggest you visit his website and give them a thorough consideration. I don’t think they are right for me personally, but I believe they are ideal for people in certain situations. They are the only way to guarantee income no matter how long you live and I agree with Joe that you should purchase an inflation rider. There have been good arguments that insurance companies overcharge for this inflation protection and that is probably true. But, I wouldn’t forgo fire insurance because I thought insurance companies overcharged for it. When you need it, you need it, and insurance won’t seem too expensive if your house burns down or a tank of gas costs three hundred dollars.

The panel discussion was a lot of fun. I hope you’ll watch the video when it is available. One of my favorite clients was able to attend in person and that was a real treat for me.

Now, I’m on to Charlotte this week to speak at the RIAA conference.

Before long, I'll be back at Caffe Driade drinking lattes, reading papers and writing blogs, but this is a nice change.

Three Portfolios

After my last post on the sensitivity of retirement finance variables to asset allocation, Asset Allocation in Smidges and Dollops, a reader commented that it can be difficult to know what to include in retirement assets and, therefore, how to calculate asset allocation percentages.

And you know what? He's right. It can get complicated.

For a 40/60 portfolio, for example, do I allocate 40% of my total assets to equity or 40% of my liquid assets? Do I include my home equity? A pension or Social Security benefits? How about a fixed income annuity?

An often-asked variation of this question is whether home equity should be included when calculating "sustainable withdrawals".

I suggest the following to make it more clear. Divide all of your assets into three portfolios.

The first, which I'll call the non-retirement portfolio, will contain any investment assets that you choose not to be used to fund your retirement. Your home equity will probably go into this portfolio. If you plan to keep your house and leave it to the kids or to a charity in your will, it goes here.

The non-retirement portfolio will also include money you set aside for your heirs, antique cars, works of art, college savings and any other investment asset that you do not plan to convert to cash to pay for your retirement. Illiquid assets should go here unless and until you convert them to liquid assets. Liquid assets can go here if you don't plan to spend them to fund retirement.

Notice I say that assets go here that you choose not to use to fund retirement. Unless you put the assets in a trust, you can change your mind, move them to another portfolio and spend them later in retirement. This is little more than a "hands-off" sign for assets you hope you won't have to spend for retirement expenses, but that will be there if you need them.

The second portfolio, which I'll refer to as the "floor" portfolio, will contain any asset that will generate retirement income but is not exposed to either market risk or interest rate volatility. This will include Social Security benefits, pensions and fixed income annuities (and probably TIPS bond ladders, though they need further discussion). These sources will provide the same amount of retirement income whether the market sinks or rises and whether interest rates rise or fall. This portfolio will provide a relatively safe floor of retirement income no matter what happens to the stock and bond markets. (I wrote about floors in Unraveling Retirement Strategies: Floor-and-Upside.)

The third portfolio, which I'll refer to as the retirement income portfolio, will contain all assets that you intend to use to fund retirement and that are exposed to market risk and/or interest rate risk. The stream of spending created by the retirement income portfolio (due to the unfortunate acronym, I won't refer to it as the RIP) depends on stock and bond market returns and is risky. Diversifying among multiple stock and bond asset classes helps manage this risk.

I'll make one last point about portfolio contents regarding our homes because it is often a subject of confusion. I initially put the home in the non-retirement portfolio under the assumption that the retiree would keep the house throughout her lifetime. (Surveys show that's what most older American hope to do.)

But, as I mentioned above, these non-retirement assets can usually be accessed for retirement income if you need them.  The equity in a home can be transferred to the retirement income portfolio as cash if you sell the home. Also, the equity can be transferred to the floor portfolio if you take out a reverse mortgage. So, there are ways for your home to provide retirement funds that you can spend, but you have to sell your home or use it as collateral before that can happen.

If you have no plans to downsize or take a reverse mortgage, your home won't be a source of retirement income and should not be used in the sustainable withdrawal rate (SWR) or retirement income asset allocation calculations.

Back to our three portfolios, let's consider their very different natures.

The non-retirement portfolio has no retirement spending rate because you have chosen not to spend from it. The investment horizon may vary for each asset. A grandchild's college costs may need to be covered in three years while investments for heirs may not be spent for decades. Depending on its contents, the non-retirement portfolio may be exposed to market and interest rate risk. Unless the assets are in a trust, you can probably transfer their value to the retirement income or floor portfolios later in retirement. Asset diversification may be beneficial in the non-retirement portfolio, but it isn't linked directly to your retirement income portfolio allocation.

(The non-retirement portfolio isn't completely irrelevant to the retirement income plan. If you have a lot of non-retirement assets, you can take a little more risk with your retirement income strategy, knowing you have these other assets available as a backup in a crisis. If your non-retirement portfolio is empty, you need to be even more careful with your retirement income portfolio asset allocation.)

The floor portfolio, in contrast, provides income that is critical to our standard of living. The assets in this portfolio are not exposed to interest rate risk or market risk. (The exception to this is a bond ladder which I will discuss in a separate post.) Though diversifying among Social Security benefits, pensions and fixed annuities might be beneficial, it is rarely practical. The spending rates for these assets are fixed by the Federal government for Social Security benefits, our pension provider, or the insurance company that sold the fixed income annuity.

Lastly, the retirement income portfolio will have a spending rate, assuming the floor portfolio doesn't cover all of our expenses. It will typically be in the 3% to 4% range of remaining portfolio assets. The assets in this portfolio are exposed to interest rate risk and market risk. The investment horizon is laddered: we will have short term needs, long term needs until the end of our life, and everything in between.

The following chart summarizes the differences between the three portfolios.

So, back to our original questions, which assets are included in the percentages for calculating sustainable spending amounts and asset allocations? The answer is the total assets in the retirement income portfolio. If we move assets from one of the other portfolios (our home equity, for example) into the retirement-income portfolio in the future, we recalculate then.

Which portfolio assets can we move in the future? We can move non-retirement assets or retirement income assets into either of the other two portfolios, though we may have to convert the asset to a liquid form (usually meaning cash) before we do.

Moving out of the floor portfolio is more difficult. We can't move Social Security benefits. Moving a pension or an annuity would mean selling it for what is typically pennies on the dollar and is usually cost-prohibitive. Bonds can be moved to either of the other two portfolios, subject to interest rate risk.

These are important things to know when we are developing a plan. Some parts of the plan can be changed to adapt to changing circumstances over time, like our asset allocation, our spending rate and which assets we hope to bequeath to our heirs and which will we use to pay our own bills.

Other parts of the plan are very difficult to move once executed, typically prohibitive to undo, like changing a Social Security benefits claim or converting a pension or fixed income annuity into cash.

As an example of the asset allocation calculation, if we have $100,000 home equity in the non-retirement portfolio and $200,000 in the retirement income portfolio and would like a 40/60 retirement portfolio allocation, we would invest $80,000 in equities and $120,000 in bonds, ignoring the home equity. How would we allocate the $100,000 of non-retirement portfolio assets? That depends on our goals for those assets, but it may be very different than 40/60.

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Our Retirement System and Some Odds and Ends

I am un-retiring for the next month or so to attend some conferences. I'll be taking my first "business trip" in ten years this week. I hope they're more fun than I remember. I'll let you know.

On Wednesday, I will be joining MarketWatch Senior Columnist and Retirement Weekly Editor, Robert Powell, who will moderate a panel discussion in New York on retirement income. Wade Pfau, Joe Tomlinson and I will be on the panel. (Wade and Joe are brilliant retirement planners; I'm the token retiree.) For more information or to RSVP, please email MarketWatchevent@wsj.com by Monday, Oct. 13^th, i.e., today.

On October 23^rd, I will speak at the RIIA Conference in Charlotte on retirement planning from the retiree's perspective. I'll be doing a webinar on sequence of returns risk in November.

My regular stream-of-consciousness posts on retirement planning for the unwealthy may be somewhat disrupted for a few weeks (if it is possible to disrupt stream-of-consciousness), so here are a couple of links you might find interesting.

The New York Times printed a piece this morning on the retirement system in the Netherlands entitled, No Smoke, No Mirrors: The Dutch Pension Plan that I found interesting.

It's interesting to compare and contrast this with an older piece in the Times by Teresa Ghilarducci on the American retirement system entitled, Our Ridiculous Approach to Retirement. These won't help your individual retirement planning except to the extent that they provide global context, but I find them interesting.

Wade Pfau's excellent blog recently mentioned a Journal of Finance paper by Gordon Irlam. Irlam uses dynamic programming to explore dynamic asset allocation. The paper is rather dense, in other words, not targeted to do-it-yourself planners, but he has a Java-based asset allocation tool at https://www.aacalc.com/ that you might want to play with. If you do, please let me know what you think by commenting below. I'll be playing with it more after I wade through the paper sufficiently.

Asset Allocation in Smidges and Dollops

How important is it to precisely nail your asset allocation in retirement? You may be spending a lot more time than you need to fretting about investing 35% of your portfolio in equities instead of 40%.

Asset allocation affects a number of retirement plan factors including your portfolio’s exposure to a market crash, your long term expected portfolio return and volatility, and your sustainable withdrawal rate (and sequence of return risk). In this post, I'm primarily referring to your equity and bond allocations, which is the first allocation decision we make.

In his earlier books, The Intelligent Asset Allocator and The Four Pillars of Investing, William Bernstein suggested that the first step in choosing your asset allocation should be answering the question, “What is the biggest annual portfolio loss I am willing to tolerate in order to get the highest returns?"

Bernstein provided a table of asset allocations based on the answer to this question. I have included this table below alongside losses for the 2007 to 2009 market crash according to IFA.com. As you can see, Bernstein's recommendations were reasonable but were more optimistic than actual losses during that crash.

(This is a demonstration of the weakness inherent in using historical data to predict future market risk and returns. The Intelligent Asset Allocator was published in 2001 and a new low-water mark was set in 2009.)

Your individual risk tolerance – at least the risk tolerance you think you have – and your risk capacity are factors that will combine to suggest an appropriate asset allocation, according to Bernstein, and you will note that a 10% change in your portfolio’s equity exposure resulted in about a 6% change in the maximum loss you might have incurred during the 2007-09 crash.

(To clarify, a 5% increase in equity allocation here means increasing stocks from 30% of the portfolio to 35%, and not to 5% more of the original allocation, which would increase equities to 31.5%.)

How precisely you need to nail your asset allocation from the perspective of maximum loss in a market downturn depends, then, on how precisely you feel you need to limit those losses. If a 15% maximum loss versus a 20% loss feels significant to you, then a 10% change in equity exposure is important. If 20% and 30% maximum losses feel about equally acceptable, your equity allocation can vary by as much as 20%.

Asset allocation also affects the long term expected return and volatility of your portfolio. During a market crash, most asset classes tend to fall. This is referred to as “systematic risk" in modern portfolio theory (MPT) and it cannot be diversified away. Over the long term, however, asset diversification is a powerful tool.

Based on index portfolios from IFA.com, using data from 1964 to present, we can see the impact of increases in equity allocation at the conservative end (a 30% equity portfolio with the remainder in bonds and cash) and the more aggressive 70%-equity end of the spectrum.

You can see, for example, in the second row of data that increasing the equity allocation from 30% to 40% would increase the expected portfolio return from 8.01% to 8.9% and the risk from 7.13% to 9.2%.

How do you choose between a portfolio with an 11.15% expected return and a standard deviation of 15.67% and a portfolio with an 11.8% expected return and a 17.9% standard deviation? These are the parameters that would change for an investor contemplating an increase in her equity allocation from 70% to 80% (the fourth row of data in the table above). Although the expected return seems to increase significantly, so does the risk and there is actually very little difference between the two portfolios.

Using a tool provided by MD Anderson called Inequality Calculator, I compared probability density functions for the log-normal distributions of both portfolios. As the diagram below shows, even after increasing equity allocation from 70% to 80%, the probability of improving annual returns of your portfolio is only about 51%.

In other words, there isn't a lot of difference between the two portfolios. You haven't turned a low-risk portfolio into a high-risk one by increasing the equity allocation from 70% to 80%.

A small increase in returns can have a significant impact on terminal wealth after 30 years. Following is another graph from IFA.com showing the growth of $1,000 in their various index portfolios from 1984 through 2013, thirty years.

At the conservative end, an increase in equities from 30% to 35% resulted in a portfolio about 12% larger after 30 years. Increasing the asset allocation from 70% to 75%, on the other hand, increased the portfolio 9.7%. Those returns, however, are not guaranteed. The odds that your portfolio will end up larger with an 80% equity allocation than with a 70% allocation is still just a tad over 50/50.

A third factor influenced by your portfolio’s asset allocation, for those implementing a sustainable withdrawal rate (SWR) spending strategy, is the sustainable withdrawal rate itself. For a demonstration of the impact, let’s look at the original studies published in William Bengen’s Conserving Client Portfolios During Retirement. 

As his charts for both taxable and tax-deferred portfolios show with 30-year life expectancies, the SWR is essentially flat from about 30% to 80% equity allocations. Unless your portfolio has a very low equity allocation or a very high one, changing your equity allocation won’t have much affect on your sustainable withdrawal rate.

Even below 30% equities, the impact on SWR is on the order of a quarter- to a half-percent and it becomes less as retirement progresses. Of the three impacts we are considering, SWR is the least sensitive to asset allocation.

To summarize, you won't change your portfolio's volatility much by changing your equity allocation a 5% or 10% step up or down. You will improve the expected portfolio return, but the probability of improving your actual return or terminal wealth is roughly a coin toss. It won't have an impact on your sustainable withdrawal rate unless you move below about 30% equity or above about 80%.

The factor most sensitive to asset allocation seems to be maximum loss in a bear market. I personally pay the most attention to this dimension of risk because I am just finishing the first decade of retirement and sequence of return risk is front and center of my attention. Bernstein refers to this as "deep risk", a risk from which one might not recover, as opposed to long-term portfolio volatility risk. Antti Ilmanen refers to it as "bad returns in bad times".

Of course, the "best" equity allocation depends on what future market returns turn out to be, which is, of course, unpredictable. If 2007 found you woefully below the equity allocation most experts would recommend, you would've enjoyed the next three years much more than they did. We're trying to find a bet that will work more often than others, not the "best" bet.

Bernstein recommends portfolio allocations in "smidges of natural resources" and "dollops of Treasuries", which tells you what he thinks about our ability to make precise bets. In his words, "Once you’ve arrived at a prudent asset allocation, tweaking it in one direction or the other makes relatively little difference to your long-term results."

Risk and the Life Cycle

I think most retirees probably have a moment not long after calling it quits when the risk of their new endeavour fully dawns on them. I think mine occurred about twenty minutes after I left the building.

Most retirees seem to intuitively sense that they have entered a stage of life with increased risk, but probably few can articulate the issue as clearly as William Bernstein.

In his latest e-book, Rational Expectations, Bernstein compares a young person who has just begun to save for retirement, a 45-year old executive who has already saved enough for retirement, and a retired person all at the beginning of the 1929 market crash.

The 45-year old in Bernstein's example saw his portfolio fall 74% by the end of June 1932, recover a bit by 1937 and fall another 48% by March 1938. Fifteen years later at age 60, he had permanently regained his 1929 purchasing power. He would ultimately have been fine, assuming he had the courage to stick with stocks through that storm. Most didn't.

The Great Depression is ultimately a boon for the young worker because he will be able to buy stocks cheap and their value would have increased dramatically over his working career. Bernstein has long pointed out that volatility and even market crashes early in life are ultimately a huge advantage for the young stock accumulator.

The retired investor, however, found himself in the worst position of the three. Without the ability to work longer, delay spending from savings, or accumulate stocks cheaply, the typical retiree would never have recovered. He would have needed a 3.6% spending rate to nurse his portfolio along for 30 years. In Bernstein's words,

"The overarching lesson of these three men, then, is that the older you are, and the fewer working years you have ahead of you (or, to use a four-bit term, the less human capital you have), the riskier stocks are. For the young saver, stocks are not that risky. For those in the middle phase of their financial life, they are quite risky. For the retiree, they are as toxic as Three Mile Island."

The important difference among these investors of different ages is human capital, or one's ability to earn wealth in the labor market. The young worker has tons of human capital and little else. The mid-career worker has human capital remaining but the retiree has almost none.

The following chart, from a Wade Pfau column in Advisor Perspective, shows the trends of human capital and financial capital over a typical lifetime. Financial capital includes your portfolio and all other financial assets. Human capital actually has a complex definition and several dimensions, but think of it here simply as the present value of all the income you will earn in the future.

The mid-career worker can use remaining but limited human capital to postpone retirement, delay spending her retirement savings, rebuild her savings over time and reduce the number of retirement years she will need to support. Her primary loss will have been not being able to retire as young as she had hoped.

The retired investor has little or no remaining human capital and must continue to spend retirement savings to live after a crash. He will continue to spend down his stock portfolio by selling when equity prices are at their lowest. He will have no cash to buy cheap equities. If retirement has a three-edged sword, surely this is it.

It is sometimes argued — incorrectly — that stocks become less risky the longer you hold them. Actually, stocks are risky no matter how long you hold them.

Stocks generally do become riskier, however, the older you get. Until well into retirement, at least. Their volatility isn't affected by your age, of course, but the financial damage that volatility can create is helpful when you are young, troubling by mid-career, and "toxic" after retirement.

That sense of fear one gets after packing his or her photos and awards into a cardboard box and carrying it to the parking lot for the last time isn't just fear of the unknown.

The trepidation isn't uncommon and certainly isn't unwarranted.

There are real sharks in that water.

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Spreadsheets and SOR Risk

People planning retirement sometimes insert a minimum successful portfolio rate of return into a spreadsheet. The thought process goes like this. "If my spreadsheet of retirement finances works when I plug in say, a 2% average expected rate of return for my portfolio, then I know my plan is safe if I earn at least that much. Surely I can earn 2%."

But that strategy won't work when sequence of returns (SOR) risk is involved. Here's why.

The terminal value of a retirement portfolio (it's balance at the end of retirement) that we spend down using a sustainable withdrawals (SW) strategy isn't solely a function of the rate of portfolio return. It is a function of the withdrawal rate, investment returns, and the sequence of those returns.

For every average rate of portfolio return, there is some probability that the portfolio will be depleted prematurely and some probability that it will fund at least thirty years depending on the sequence of the returns. If the portfolio enjoys a high average rate of return over the 30-year period, the probability that it will be derailed by SOR risk is quite small. Likewise, if the average return is quite low over that period, the portfolio will probably fail, perhaps even without the nudge of a poor sequence of returns.

But in the range of average returns that you are most likely to experience, say between about 2% a year and 6%, SOR risk will often determine failure or success.

To illustrate, let's look at historical returns using the Robert Shiller data and the spreadsheet from the Retire Early Home Page and see what the historical results would have been for 2% real rates of return over past 30-year periods with a 4% withdrawal rate.

Historical stock market data is very limited. Shiller's data back to 1871 provides 142 years of data, but that is less than five unique 30-year periods. We try to stretch this number in a somewhat-flawed statistical manner by using rolling 30-year periods of historical data, but there are still only 112 of those. That is a relatively small sample for our purposes and no periods experienced 2% rates of return. Nonetheless, the terminal portfolio values for a $1,000 portfolio of 50% equities and using a 4.5% withdrawal rate with historical returns data can be shown as follows.

There were no periods with real 50% equity portfolio returns of only 2%, the rate of return I was hoping to investigate. There were so few periods in the sample, in fact, that I had to increase the withdrawal rate from 4% (the one I actually wanted to investigate) to 4.5% just to show a few more failures. Regardless, you can see that some portfolios historically failed with 4.5% rates of return while some successfully funded 30 years of retirement with only a 3.5% average return due to sequence of returns (SOR) risk. In fact, during this period of historical data, portfolios would have failed with real rates of return as high as 4.4% a year while others succeeded with returns as low as 2.8%.

Because there is such a small sample of historical data to work with, we sometimes use Monte Carlo simulation to test hypotheses. (A reader recently complained that I should use historical data more often, a strange complaint given that I very rarely use anything else, but this is an example of when we really need simulation to explain a point because the historical data is inadequate.)

I used the simulation from The Implications of Sequence of Return Risk to generate a similar graph. This simulation provided not only several scenarios with 2% portfolio returns, but produced a number of failed scenarios with a 4% withdrawal rate. The simulation provided 10,000 unique 30-year scenarios.

Notice in this graph that I rounded rates of return along the x-axis to the nearest one percent. Instead of producing a cloud of outcomes as in my previous post, this chart displays a vertical bar (actually a cluster of points) of the terminal portfolio values (TPV's) that demonstrate the range of outcomes for each rounded rate or return. (In effect, I scrunched all the outcomes from portfolio returns of 1.5% to 2.5% into a vertical bar above "2%", for example.)

Also note the yellow marker inside each vertical bar (double-click the chart to enlarge). That point marks the terminal portfolio value that would have resulted from a 30-year sequence of identical returns – in other words, it's the expected TPV with no SOR risk. This is the highly unrealistic scenario that would be generated by a spreadsheet or consumption-smoothing models that don't randomize returns.

Using spreadsheets and other tools that don't randomize returns, the yellow markers would seem to indicate that any return of 2% or greater would result in a retirement plan using the SW strategy successfully funding 30 years. But in reality, only 66% of the simulated scenarios with returns from 1.5% to 2.5% succeeded. The spreadsheet looks fine, but there is actually about a one in three chance of failure with this rate of return. And as we saw above, sometimes a lower return would have succeeded and sometimes a higher return would have failed.

What if I plug in 1% instead of 2% for my portfolio's rate of return and my spreadsheet still works? That's gotta be a good sign, right?

You've actually made the outcome less predictable.  Scenarios with 1% average returns in the simulation had about double the SOR risk of 2% returns. If you're looking for the lowest rate of return for your spreadsheet that will very likely be successful, insert a higher rate of return, not a lower one.

That's why we can't plug a low average rate of return into a spreadsheet or other planning tool that doesn't randomize returns and gain confidence from the results that our plan will definitely work.

Often it will. Sometimes it won't.

If you plan to implement a SW strategy, be aware that unless you randomize the returns in your spreadsheet, you won't see SOR risk. I'm not suggesting that you shouldn't plan for retirement using a spreadsheet or E$Planner, only that you should do so carefully.

The Implications of Sequence of Returns Risk

Some time ago, I wrote a series of posts on Sequence of Returns (SOR) risk. The focus of those posts was to explain what SOR risk is mathematically and where it comes from (periodically buying or selling from a volatile portfolio of stocks and bonds).

If you plan to fund retirement by selling off assets from such a portfolio, it is vital that you understand what SOR risk is, its source, and how it impacts your finances after you retire. I won't repeat the first two points about definition and source here, so you might want to review my earlier posts before proceeding, but I do want to expand the discussion regarding the implications of SOR risk.

As I mentioned, SOR risk is a result of periodically buying or selling from a volatile portfolio of stocks and bonds, as retirees do who implement a systematic withdrawals (SW) strategy. They're going to sell stocks every year for perhaps 30 years or more and with no idea what future stock prices will be when they eventually sell. That uncertainty is SOR risk.

In contrast, if they bought the exact same portfolio and held it intact for thirty years, the sequence of returns would make no difference in the portfolio's terminal value, whatsoever.

SOR risk is also present in the accumulation or "saving" phase of financing retirement, but its impact appears to be less severe than during the spending phase and it is more controllable. We sell assets in retirement because we have an urgent need to spend the money, even if we are forced to accept a low price, but we can easily postpone purchasing stocks during the accumulation phase when prices are high by leaving our savings in cash for a while.

Selling a constant dollar amount every year exacerbates SOR risk because it means that we will sell more shares when prices are low, which is, of course, the opposite of what we would prefer. Selling a percentage of remaining portfolio balance every year instead would help us sell fewer shares when prices are lower, but would leave us with an unpredictable income stream. (I still think that is the preferable approach. When you have less wealth, you should spend less.)

Bonds held to maturity, annuities, pensions and Social Security benefits, on the other hand, are not subject to SOR risk. The portion of our retirement spending provided by those sources is not affected by stock market price variance. In fact, even bond funds that do not hold their bonds to maturity but have low volatility will have only a little SOR risk.

So, the first way that SOR risk impacts retirement finances is that it is only present when we buy or sell from a volatile portfolio. Retirees with little or no stock exposure will have little or no SOR risk. The second way it impacts retirement finances is that it has a greater impact during spending than during accumulation. A poor sequence of returns when we are saving reduces our accumulated wealth, but during the spending phase a poor sequence can take us out of the game entirely.

In finance, risk is often defined as the uncertainty of outcomes. Unlike the everyday connotation of the term "risk", uncertainty can be both good and bad. A risky portfolio of stocks and bonds has greater potential for both gains and losses than a less-risky portfolio. Risk is where we make our money on investments. Risk-free investments do well to cover inflation.

In the same sense, sequence of returns risk can leave you with more wealth or less wealth. The most wealth during the spending phase comes when a sequence of returns is ordered from the best return first to the lowest return last. The least wealth comes when that same sequence is ordered from worst return first to best last.

In the saving phase, the opposite is true. We want the best returns later in life when our portfolios are larger, and we mind losing money less when we are young and have little to lose.

SOR risk is completely unpredictable. Diversifying your stock assets won't reduce this risk and the market cannot compensate you for it. In that sense, it's a "bad risk". A good risk would be one that we can be compensated for taking.

Much is made, and rightly so, of the fact that big portfolio losses early in retirement can devastate your portfolio. Wade Pfau estimates that your returns in the first decade of retirement explain about 80% of portfolio survival for thirty years. I have seen simulated scenarios with correlations near 90%. This is a result of SOR risk and is a direct result of my previous statement that "the least wealth comes when that same sequence is ordered from worst return first to best last."

An important consequence of sequence of returns risk is that our terminal portfolio value, what we have remaining to leave to heirs, can be dramatically different even with the same portfolio returns.

Following is a scatter plot of terminal portfolio values (TPV) versus portfolio returns. I created this from a simulation of 10,000 scenarios of annually spending 4% of initial portfolio value for 30 years from a 50% stock portfolio with a geometric mean return of 5.6% and a standard deviation of 11%. Each blue dot on the chart represents a scenario's TPV when the average return equalled amounts along the x-axis. (I let the portfolio values run negative, even though your broker won't, because cutting off the portfolio values at zero graphically hides some information.)

Notice that the very bottom of the blue crescent area of terminal portfolio values drops below the zero portfolio value line (x-axis). In the following chart, I zoomed in on the area between 1% and 6%, where portfolios both succeed and fail.

If you look directly above 4%, for example, you will see that many portfolios had TPV's greater than zero and many showed negative TPV's even though they all experienced 4% average growth annually without spending.

Again, SOR risk results in a broad range of outcomes even with the same market return.

SOR risk can exacerbate other risks, as well.

Imagine that you are retired and have a mortgage, so you have foreclosure risk. If your mortgage payment is paid from the sales of stocks in your retirement savings portfolio, then a poor sequence of returns could jeopardize your ability to make those payments. Your home is now subject to a greater risk of foreclosure than if your entire mortgage were paid from pension benefits or an annuity, for example.

The last thing I want to point out about SOR risk in this post is that, as the chart above shows, some portfolios failed with a 6% portfolio return, while others funded thirty years with portfolio returns of only 1% or 2%. The former had a poor sequence of annual returns while the latter had a fortunate sequence.

So, those are eight things you need to know about sequence of returns risk (I italicized them), and here's one more.

If stock investing weren't risky enough, once we start spending from a portfolio and exposing ourselves to sequence of returns risk, our financial success in retirement is not solely a function of the rate of return we earn. It also depends on the sequence of returns. An SW portfolio can fail when average returns from the market do relatively well and survive when average market returns are relatively modest.

I'll pick up there in my next post.