Your Own Personal Fiscal Cliff

Each of us faces a personal "fiscal cliff" when we retire. The challenge of avoiding that cliff can perhaps best be shown with a graph of typical lifetime income.

The green columns represent your lifetime earnings and the red columns your lifetime expenses. The problem, of course, is that earnings stop when you retire, but expenses don't. That's only a problem if you live long enough to retire, but it becomes a really big problem if you live to age 95 or 100.

See the earnings after age 65? That's a fiscal cliff.

This may surprise you if you are 25 (I didn't give it a lot of thought back then), but if you live long enough, one day you will no longer be able to work for a living but you will still need to eat.

Economists tell us that we can "smooth consumption" by saving when we have lots of income and borrowing when we have less.  The principal assumption behind consumption smoothing is that people don't want to live royally while they are working if it will mean living as a pauper after they retire. Nor do they want a lavish retirement if it means scrimping for the forty years prior. Instead, the assumption is that people would prefer similar standards of living before and after retiring.

The approach has its limits. No one (except your parents, perhaps) will loan you much money when you are 25 because you expect to earn a lot when you are 55. Also, when you're 25, you haven't saved a lot of money so you can't borrow much from your own savings.

Nonetheless, it seems reasonable that we can smooth our lifetime income to some extent at certain times of our life when we are not "borrowing-constrained".

A good time to smooth our consumption (spending) would be between our working years and our retirement years. Rather than spend all of our money while we are earning it, we could delay some of that consumption until after we retire.

We could save money while we are working so we can spend it after we retire and that reduces our standard of living before we retire. We could also just spend less after we retire, reducing our standard of living when we are older. The idea behind consumption smoothing is that you minimize the differences so you have a decent standard of living before you retire and a similar one after.

If you save too much while you work, you unnecessarily reduce your standard of living before you retire. Save too little, and you see a big decline in your standard of living after you retire.

Even saving enough is an incredible challenge, so I wouldn't worry a lot about saving too much. In retirement planning, the first goal is to avoid the worst case scenarios and that would be saving too little and running out of money before you die. Unfortunately, as I have explained in prior posts, it is nearly impossible to know how much "enough" is.

The challenge, then, is to balance your standard of living before and after retirement while having no good way to predict either. Here's a "save too much" chart, a "save too little" chart", and an "ideal savings" chart.

None of the figures behind these charts is even a little predictable (your lifetime earnings, your lifetime expenses, how long you will live, etc.), but we can use them to see the principles we should establish for paying for our retirement years. Like a lot of things in the field of economics, the models are better at explaining how things work in general than they are at predicting outcomes with any precision.

The idea is that we can lower the red line on the left side of the chart by saving and then spend those savings after we retire, which raises the red line on the right. The closer we bring those two parts of the red line toward the green line in between, the more our standard of living in retirement is like the one we had while we were working.

(It works in reverse for the blue line, which represents the unlikely "oversaving" scenario.)

There is an excellent paper on the subject entitled The Theory of Life-Cycle Saving and Investing by Zvi Bodie if you're interested in a more rigorous explanation. There is also an excellent website and software product ($ESPlanner) created by Professor Laurence Kotlikoff if you'd like to play around with consumption smoothing.

So, in a nutshell, the Standard of Living v. Savings chart above explains retirement planning: finding the maximum standard of living line before retirement that you can sustain after retirement. In other words, to save the amount that moves your consumption close to the green line.

Next, in Moving the Red Line, we'll talk about how to move those lines.

Average Annual Returns Mean Less Than You Think

Ask anyone what stock market returns they should expect and they will quickly respond with something like 8% or 10%. Ask them how they arrived at that number and they will tell you it's the historic market return average, more often than not meaning the S&P 500 index.

The time period we use to calculate that average can have a significant impact on those numbers. Do we measure the real returns since 1871 provided by Robert Shiller of about 6.7% a year? Do we measure from the Great Depression (about 7.5%)? The end of World War II (about 6.5%)? How about the past 50 years (about 7.6%)?

(These are real “after inflation” returns. Nominal returns are about 3% higher.)

No matter how you measure, compound growth rates (CGR) are probably less important than you think.

Market averages tell us how a market index performed over a given time period. There are 1,332 rolling 360-month periods of S&P 500 market returns in the Robert Shiller data from 1871 through 2012. The average real return for those periods was 6.7% a year (8.9% after inflation). But as an individual with a 30-year retirement, you would have lived through only one of those periods.

It might have been one with a 6.7% real return, or it might have been the one with a whopping 11.2% annual return on the right of the chart above. Then again, it might have been the one with the 1.9% annual return on the left. The average doesn't imply as much with a one-time event like an individual retirement. If you lived several hundred lifetimes, 6.7% would be a good bet (but retirement planning would be a bear).

As I showed in recent posts on the topic of sequence of returns risk, a retiree might earn 3% annually and successfully fund thirty years of retirement. But she can also earn an average 7% and go broke in less time. The order of the market returns can be even more important than the average of those returns if you choose to spend down a stock portfolio after you retire.

Lastly, no one earns market index returns over the long run. You will undoubtedly experience lower returns than “the market average”.

If your retirement plan is based solely on expected market return averages, you should probably give it a second look.

Imagine a punch bowl with 1,332 little pieces of folded paper, each with one of those market returns. You get to reach in and pull out a number to decide your fate. 650 of the papers represent returns of 6.5% or greater but 682 are less. 78 are less than 4% and 9 are less than 3%.

You get one turn.

But is investing for retirement really as random as pulling a piece of paper out of a punch bowl?

Yup.

It mostly depends on when you were born.

When to Stop Betting

I have a friend who keeps asking me if the stock market is going up or down. My answer is always, “Yes, it is.”  But he keeps asking.

He never asks in the same way twice. One time it’s, “Should I wait to sell my stocks until after the government shutdown?” Another time it’s, “Should I wait to sell stocks until my portfolio reaches a million dollars?”

I have answered in several different ways, each time explaining that no one knows whether the market is going up or down. No one. Ever.

Oh, everyone guesses and some of them will be right, but no one prognosticator is right consistently. As my grandfather used to say, even a blind chicken finds a kernel of corn now and then.

Once I reminded him that our mutual friend lost his entire savings, four million dollars, a few years before retiring by trying to eke out a few more dollars from his tech stock.

I’ve told him I knew dozens of paper millionaires at AOL who rode their stock options from $102 a share to worthless, convinced the entire way that the stock would recover if they just hung on long enough.

This is probably the most important thing to understand about investing. No one knows where the market is going.

Behavioral finance tells us that we want to believe that we are all above-average investors, like the children in fictional Lake Wobegon. Studies show us that most investors’ returns actually lag the returns of the funds they invest in and no fund consistently beats market averages.

To quote Morningstar, “In fact, in every diversified stock-fund category and all but a handful of sector categories, funds' 10-year investor returns lagged their total returns. The divergence was, in several cases, quite striking.”

The problem, as Morningstar notes, is that investors pick poor times to buy and sell. Fund return averages look better because they never sell.

So, most fund managers under-perform market indices and most investors under-perform the funds they purchase. Yet, we still want to plan retirement based on historical market index returns.

Another thing we want to believe is that there is an intrinsic 8% (or 10% or 12%) return to be had in the market if we just find the right system. Dollar cost averaging, buy and hold, systematic withdrawals. If we believe in the fairy dust, in time we’ll get our 8%.

An analysis by Business Insider, however, shows that since 1871, the stock market has returned an 8% or more annual CGR in only 21% of the 240-month (20-year) periods.

The idea behind dollar cost averaging is that making smaller sales or purchases over time might be safer than making one large bet immediately. That theory was debunked ages ago. You’re better off taking the plunge.

So, will waiting to buy or sell result in a loss or a gain? 

Yes, it will. I just can’t tell you which.

What I keep telling my friend is that the only answerable question is whether he is ready to stop betting.

And only you can answer that.

When You Have Less Money, You Probably Ought to Spend Less

In the late nineties I read about safe withdrawal rates (SWR) and became fascinated by the concept, since I was planning to retire in the next five to ten years at the time.

SWR strategies are the ones you read about in financial magazines, like Money, that say you can invest your retirement portfolio in stocks and safely spend 4.5% of your portfolio’s initial balance annually after you retire. If you retire with $100,000, for example, they say you can safely spend $4,500 every year and your money is likely to last 30 years.

It was an attractive proposition. You could have thirty years of annuity-like payouts and still leave a huge portfolio to your heirs — in a few hypothetical scenarios, at least.

SWR advocates say you can keep spending $4,500 a year even if your stock portfolio plunges in value when the market crashes. (After crashes, they usually say, “Well, we didn’t mean that literally.”)

I think they’re a bad idea, but like dollar-cost averaging, SWR strategies continue to be popular despite loads of studies showing them inferior. Both approaches generate a lot of stock and mutual fund business, so I’ll leave it to you to figure out why Wall Street pushes them.

I not only read about the strategies, I built my own models and monte carlo simulators (I began my career in computer science). I got to know every picky little detail of how they work and, consequently, began to understand the problems with constant-dollar spending strategies.

Soon, I abandoned them. They looked like a dead end to me.

I understood, statistically, how retirement portfolios in the spending phase could reach a tipping point with the SWR strategy and then begin a downward death spiral. As even SWR advocates will tell you, it happens about 5% of the time with constant-dollar withdrawals of 4.5% of the initial portfolio balance.

I never really thought about models that would spend a fixed percentage of remaining portfolio balances each year instead of a constant-dollar amount, but lately I had the opportunity. I was comparing withdrawals of $45,000 a year from a million dollar portfolio (4.5% of initial balance) to withdrawing 4.5% of each year’s remaining portfolio balance.

I used real S&P 500 returns from Robert Shiller’s website to generate rolling 30-year sequences from 1871 to 2008. Nine of these 108 scenarios ran out of money in less than 30 years, for a failure rate of 8.3%, but one lasted 28 years and one 29 years, so let’s round it down to a 6% failure rate and toss a crumb to the SWR crowd.

The thing that surprised me was what happens to percentage-withdrawal portfolios in the scenarios where constant-dollar portfolios fail, the nine in this example.

I guess I always assumed that percentage-withdrawal strategies would also fail, but that they would just keep paying out insignificant percentages of smaller and smaller portfolios. I expected them to fail, just without a clear point of demarcation like you have with constant-dollar strategies. If the economy were bad enough to decimate a constant-withdrawal portfolio, could any other strategy be that much better?

But when I looked at the nine failed scenarios, that isn’t what happened.

Sure, bad stretches of market returns generated lower annual payouts, but making smaller withdrawals when the portfolio was under pressure eased that pressure enough to allow those portfolios to recover. In fact, only one of the portfolios ended up with a value less that $1M after thirty years (see table below) and it held over $870,000.

Strategies that spend a constant amount every year from a stock portfolio, such as the safe withdrawal rates strategy, are quite binary. You either get lucky and fund your entire retirement with a steady stream of income, or you go broke in your dotage.

Percentage-withdrawal strategies don’t provide consistent payouts, but you’re far less likely to end up in the poorhouse. In fact, your chances of leaving that big check for your heirs are better.

Percentage-withdrawal strategies, unlike constant-dollar withdrawal strategies, work on the time-proven financial principle that, after you lose a lot of money, you probably ought to spend less.


Table 1. TPV of 9 Scenarios that
Failed with Fixed Withdrawals

4.5% Withdrawals	$45,000 Withdrawals
$1,251,877	$0
$1,871,837	$0
$1,015,742	$0
$870,190	$0
$1,041,979	$0
$1,447,398	$0
$1,632,138	$0
$2,005,257	$0
$1,254,348	$0

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.

Sequence of Returns Risk or Something Else?

I've read many columns and papers about how devastating large losses can be to a portfolio when those losses occur early in retirement. Usually, this risk is referred to as Sequence of Returns (SOR) risk and it is illustrated by showing a few market returns and how they provide the same ultimate portfolio value no matter how they are ordered. Then, the column shows how the order becomes significant when we buy or sell stocks periodically from the portfolio. 

Hopefully, you followed my explanation in my two previous posts, Clarifying Sequence of Returns Risk Parts One and Two.

I agree that large losses early in retirement can be potentially devastating, and that SOR risk is introduced when an investor withdraws constant-dollar amounts from a retirement portfolio. I just don't see them as the same thing.

Let’s imagine two workers who retired on October 1, 2007, each with a 100% stock portfolio worth a million dollars. One plans to spend $45,000 every year from his portfolio. The other plans to buy a fixed annuity with the entirety of his portfolio sometime in the next month. As I explained in previous posts, the constant-withdrawal retiree is exposed to sequence of returns (SOR) risk. The fixed annuity buyer obviously is not.

From October 8, 2007 to March 2 2009, the S&P 500 fell nearly 55% in just 16 months. Our two retiree-investors are both now looking at portfolios worth about $450,000 and I would argue that, despite having different spending strategies, they are about equally screwed.

The risk of the sequence of future returns is of no consequence to the annuity buyer and for the constant-dollar spender, SOR risk will seem like a minor annoyance compared to his recent loss of more than half his portfolio.

Their problem is clearly not Sequence of Returns risk as I have discussed it.

I see their problem as having made an extremely large bet on stocks at the riskiest time in retirement and I refer to it as "early loss" risk.

The bet is extremely large because the typical pattern for a retiree-investor results having his or her their largest portfolio value just before and just after retirement. The following graph shows portfolio value for a worker who invests $6,000 a year while working, and spends $50,000 a year in retirement with a constant 8% rate of return. Even with significant changes to portfolio allocation, the worker will make his largest bets on the stock market (i.e., have the largest portfolio to invest) in the decade before and the decade after retirement.

Why is early retirement the riskiest time? Ignoring the size of the annual bet, which is in and of itself an increased risk, portfolio values in the decades before and after retirement have the greatest impact on terminal portfolio value.

Here’s a simple example. Assume that a retiree can earn 5% every year of a 30-year retirement with no risk and will spend $43,000¹ each year. I replaced the 5% gain with a 30% loss in the first year of retirement, then moved the 30% loss to the second year, etc. To be clear, each scenario contains just one 30% loss and 29 five percent gains, with the loss marching through the years.

A 30% loss in the first year of retirement left only $24,000 in the terminal portfolio. The same 30% loss in year 30 leaves over $962,000.

With no losses, the portfolio would have ended with a value of nearly $1.5M. As you can see from this simple demonstration, the earlier in retirement a major loss occurs, the greater the impact on future wealth.

A 30% loss in year one had 25 times the impact of a loss in year thirty when comparing TPV’s.

(Wade Pfau posted a similar analysis today. He uses maximum sustainable withdrawal rates, instead, but comes to the same conclusion.)

So, put these two charts together and you see that the typical retiree will place her biggest stock market bet at the riskiest possible time.

That’s why I refer to this as “early loss risk” instead of SOR risk and why I see it differently than the SOR risk I have explored in my past few posts.

The obvious solution to this problem is to lower stock allocations early in retirement and perhaps increase your allocation as early loss risk eases². That is exactly what Wade Pfau and Michael Kitces recently proposed.

To some extent, the differences between “my” SOR risk and SWR advocates’ SOR risk is semantic. They’re saying that if you implement a constant-dollar withdrawal strategy and have losses early in retirement you’re in deep doodoo. I’m saying that a large early loss is bad no matter what your spending strategy.

In a more important way, they're different. Large early losses with a constant-dollar spending strategy frequently result in the retiree going broke, while losses with a strategy based on a proportion of remaining portfolio balance threaten the retiree’s annual income, while allowing her portfolio to survive.

Either way, if you hold most of your wealth in stocks early in retirement, you have enormous risk, as many recent retirees and near-retirees learned in 2007. I was one of those, and it gave me an entirely new perspective on stock market risk.

I held 40% stocks at the market peak in 2007. I recently advised a friend to hold 20% or less.

It certainly changed my idea of “conservative allocation”.

In my next post, "Sequence of Returns Risk: What's That Mean", I'll tie up a few loose ends on this topic.

---

¹ I reduced this from $45,000 to avoid portfolio failure in less than 30 years for the worst case.

² It never goes away. Whatever your current age in retirement is the riskiest investment year of the rest of your life.

MarketWatch Says I'm Thoughtful

MarketWatch says I'm thoughtful.

And I quote, "Dirk Cotton, a financial planner based in North Carolina, runs a thoughtful blog called The Retirement Cafe. Recently, he has been writing on the idea of sequence of returns risk."

This is so cool. I'm printing off a copy of the post to show my wife next time the subject of thoughtfulness is broached.

But seriously, I am humbled and appreciate Wade Pfau's picking up my post. If I can convince you to follow Wade's blog, my work here will have been worthwhile.

If you're interested in Sequence of Returns risk, I hope you'll read my series on the topic beginning with Sequence of Returns Risk Part One. I still have a few more posts to go on the subject before I finish.

Part of my goal for this blog is to explain the financial issues of retirement in a way that anyone can understand. To make it more "accessible", as they say. I haven't done a great job of that with SOR risk so far because it's a pretty technical issue, but I hope to fix that.

I have to read papers that Wade and others write several times before I understand them, and then cogitate, as my grandfather liked to say. I know most people have neither the time nor the interest to do that.

I plan to tie it all together in a more accessible way in the final post on the topic over the next week or so that I will call "What's That Mean?" Please stick with me.

Also, I have added a Follow Me by Email widget to the site if you would like to be notified of new posts. You're email address won't be used for anything else. I also added a small ad widget at the top left. If you see something interesting, give it a click.

I'm not trying to make money with this blog, I'm trying to think through my own retirement finances and figure out what to tell my kids about theirs. I share my thoughts to help my fellow Baby Boomers.

That and a great cup of coffee at Caffe Driade is a fun way to while away a few afternoon hours.

Thanks for reading.

Sequence of Returns Risk and Payouts

As I mentioned in previous posts, the web is replete with columns about sequence of returns (SOR) risk showing that the order in which we experience market returns matters when we begin spending constant-dollar amounts from our portfolios.

I previously showed how you can eliminate the SOR risk from terminal portfolio values (TPV) — the amount of money in your portfolio at the end of retirement — by basing your retirement spending on a constant percentage of remaining portfolio balance. But, I didn’t talk about the payouts of spending strategies, which is an important point missed by every other SOR risk column I have read.

Using the six annual returns:

-19.76%

-9.37%

7.96%

-0.86%

27.33%

14.88%

let’s look at both TPV’s and their payouts from both spending strategies (constant-dollar withdrawals and percentage of remaining balance withdrawals) using the 720 possible orders of these six returns.

In the first scenario, a retiree has a stock portfolio valued at $1M and she withdraws $25,000 a year. The second is identical, except the retiree withdraws 2.5% of her portfolio’s remaining balance every year.

Here are the results[i] for the 720 sequences for $25,000 withdrawals in graph format.

With constant-dollar withdrawal amounts, the annual payout is always $25,000 (by definition) but the terminal portfolio value depends on the order of returns.  TPV’s ranged from $931,049 to $1,015,467.

Remember what we are doing here is not looking at different sets of market returns, but at the 720 different ways this set of six returns can be ordered.

And, here are the results[ii] for 2.5% withdrawals of remaining portfolio balance each year.

With percentage withdrawals, TPV is $979,537 no matter how the annual returns are ordered, but annual payouts range from $16,553 to $36,986 and the present values (PV) of those annual payouts discounted at 2% range from $108,000 to $182,000.

SOR risk affects payouts but not terminal portfolio values when spending is based on remaining portfolio balance.  It affects terminal portfolio values but not payouts when spending is based on anything else. So, SOR risk is going to show up somewhere.

We get to decide which place by picking a spending strategy.

You might expect that eliminating SOR risk with respect to terminal portfolio values simply generates the same amount of wealth while varying the payouts and holding the TPV’s constant, instead of the reverse.

It doesn’t.

When we transfer SOR risk from terminal portfolio value to payouts, we don’t transfer an equal amount of risk. Here’s an example.

Since both terminal portfolio values and annual payouts are important, I measure retirement wealth as the present value (PV) of all payouts in retirement plus the present value of the terminal portfolio, as if it were paid back to the retiree after 30 years. I use a 2% discount rate and consider the two scenarios above (2.5% withdrawals and $25,000 withdrawals).

First, I looked at all 720 possible sequences of the six annual market returns.

PRESENT VALUE OF RETIREMENT WEALTH WITH ALL PERMUTATIONS OF SIX ANNUAL RETURNS

	PV of Terminal Portfolio	PV of Payouts	Total PV	Average Total NPV	Std. Dev.
2.5% Withdrawals	869,801	107,853 to 182,068	977,654 to 1,051,869	1,010,627	16,621
$25,000 Withdrawals	826,745 to 901,705	140,036	966,780 to 1,041,741	1,008,407	16,789

The ranges of outcomes are the result of SOR risk. They use the same 6 annual market returns, but in every possible combination. In particular, look at the Total PV column. These are the ranges of 720 possible outcomes as measured by the combined present values of payouts and terminal portfolio values.

The results aren’t very different after 6 years. Percentage withdrawals do only a little better by every measure. But recall from my earlier post that SOR risk grows exponentially with time and these differences might be much more pronounced over longer periods.

Next, I looked at a thirty-year sequence. Fortunately, we don’t have to run all 2.65 x 10³² permutations of 30 years of returns (when is the D-Wave quantum laptop hitting the market?) because we know the best-case scenario is when the annual returns are ordered highest to lowest and the worst-case scenario is the reverse.

I looked at the sequence of real market returns from 1979 to 2008 from Robert Shiller’s website and ran both spending strategies with that data for the best-  and worst-case sequence of returns. Here is what I found:

PRESENT VALUE OF RETIREMENT WEALTH

BEST- AND WORST-CASE SEQUENCES FOR MARKET RETURNS 1979 TO 2008

	PV of Terminal Portfolio	PV of Payouts	Total PV of Retirement Wealth
Worst Sequence of Returns
2.5% Withdrawals	3,100,060	487,892	3,587,951
$25,000 Withdrawals	431,240	559,911	991,151
Best Sequence of Returns
2.5% Withdrawals	3,100,060	4,893,631	7,993,691
$25,000 Withdrawals	5,604,748	559,911	6,164,660

Percentage withdrawals are significantly better in both the best and worst cases.

Now, a couple of important points. First, while I had been using 4.5% and $45,000 in previous examples, I had to change the withdrawals to 2.5% and $25,000 in this step because the constant withdrawal portfolio failed in its twelfth year with $45,000 withdrawals in the worst case.

This brings out an important point regarding the two strategies. The constant-dollar withdrawal strategy, as is well advertised, leaves the retiree flat broke before retirement ends 5% to 10% of the time. Percentage withdrawals never do, though payouts will decline as the portfolio values drops.

This is the worst case of SOR risk. Not that constant-dollar withdrawal strategies cost more, or that we aren’t compensated for the risk, but that portfolio failure[iii] is a real possibility.

Second, I am not trying to show that one of these two spending strategies outperforms the other. There is plenty of research to show that constant-dollar withdrawal strategies underperform. At these two extremes, in this specific example, percentage withdrawals look much better, but there are plenty of sequences in the middle where constant-dollar withdrawal shows better results, including the actual 1979 to 2008 order, where $26,842 withdrawals generated a PV of  $5M compared to $4.7M for 2.5% withdrawals.

I will note, however, that I have tried many 30-year sequences of returns and I am yet to find a set of returns where percentage withdrawals did not dominate constant-dollar withdrawals in the best and worst-case sequences using present value of combined payouts and TPV’s.

What I am trying to show is that shifting SOR risk from terminal portfolio values to annual payouts isn’t a wash.

Given the 30 annual market returns in this example, 2.5% withdrawals provided outcomes from $3.6M in the worst case to $8M in the best. That’s the range of outcomes if we remove SOR risk from terminal portfolio value.

$25,000 withdrawals generated about $1M in the worst case and $6.1M in the best. So, switching from constant-dollar to percentage withdrawals not only switched SOR risk from TPV to payouts, it provided higher value and lower risk. And it completely avoided portfolio failure.

That’s consistent with the many studies that show constant-dollar withdrawal strategies underperform.

Notice that the differences in sequence of returns risk is much more pronounced at 30 years than at six. Since SOR risk is partially the result of the uncertainty of stock prices along the path (it isn’t present in a buy and hold strategy) that is what we should expect.

So, we can eliminate SOR risk from terminal portfolio values, or eliminate it from annual payouts, but not both. If we eliminate it from annual payouts, we introduce the risk of portfolio failure.

By basing our spending strategy on a constant percentage of remaining portfolio values, we can shift SOR risk to annual payouts, where it seems to do less harm.

Personally, I’d prefer risking my annual income to risking the source of all future annual income, even if it were an even trade, but it is not.

Next up: Sequence of Returns Risk or Something Else?

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[i]

CONSTANT-DOLLAR WITHDRAWALS OF $25,000 ANNUALLY

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Market Return		-19.76%	-9.37%	7.96%	-0.86%	27.33%	14.88%
Portfolio Balance	1,000,000	777,400	679,558	708,650	677,556	837,732	937,387
Payout		25,000	25,000	25,000	25,000	25,000	25,000

[ii] 2.5% OF REMAINING BALANCE WITHDRAWALS

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Market Return		-19.76%	-9.37%	7.96%	-0.86%	27.33%	14.88%
Portfolio Balance	1,000,000	777,400	685,123	722,530	698,253	871,630	979,537
Payout		25,000	19,435	17,128	18,063	17,456	21,791

[iii] By “portfolio failure” in this case, I’m referring to depleting a portfolio before the end of retirement.