This article originally appeared in the May 2015 issue of the AAII Journal.
It’s a fact that the order in which you experience positive and negative returns significantly impacts how your portfolio performs. The big uncertainty is what actual sequence of returns you will experience in the future.
It is impossible to predict how the markets will perform over an extended period. While valuation measures, for instance, can offer insight into the prevailing long-term attractiveness or elevated risk level of the market, they cannot accurately predict how stocks will actually perform in the future.
The sequence of positive and negative returns is particularly important during the period surrounding the transition into retirement when you move from accumulating assets to drawing down your savings.
This is the reason so many asset allocation models call for a portfolio to become more conservative as retirement approaches, and even continuing to get more conservative once in retirement. If large cash flows are needed and future returns (especially over the next one to five years) are unknown, it is prudent to take steps to minimize the chance of a large drop in portfolio value. A steep decline in wealth at an inopportune time can greatly increase your longevity risk, meaning the risk of outliving your savings.
An easy way to understand the concept of sequence of returns is to look at a chart. Figure 1 shows how a different order of returns would have affected the same portfolio over a period of time.
The portfolio has a starting value of $100,000 allocated to 60% large-cap stocks and 40% bonds performed over the period of 1988 (Year 0) through 2014 (Year 27) using the actual returns of two Vanguard mutual funds and no changes (neither withdrawals or rebalancing) made (“Actual” line).
The chart also shows how the same portfolio would have performed if the year with the highest return occurred first and each subsequent year had lower a lower rate of return (“Best to Worst”) as well as if the order were reversed so that the year with the worst return occurred first and each subsequent year had a higher rate of return (“Worst to Best”). The Best to Worst scenario experienced the most upside (nearly $2.5 million) because of compounding and 22 consecutive years of gains.
Even though the paths are different, all three scenarios end up in the same place. This is because under hypothetical conditions, as long as no changes are made to the portfolio, the cumulative return is the same. The only thing that is altered is the order, or “sequence,” in which the annual returns occur. If any changes to the portfolio are made at a given point in the time, then two moving parts affect the eventual the outcome: the sequence of returns and the impact of making a change to the portfolio at one or multiple points over the specific period.
How is your portfolio affected during good and bad sequences if you are taking withdrawals in retirement?
When withdrawals are being made, two big factors influence whether a portfolio will last a person’s lifetime. The first is the outflow of dollars to support a person’s (or a couple’s) lifestyle. These outflows reduce the portfolio’s size at the time the withdrawal is made. The second is the return on investments. A positive return, particularly one in excess of the withdrawal amount (e.g., 4% of portfolio value) can extend the number of years a portfolio lasts. A negative return can shorten a portfolio’s duration.
Figure 2 illustrates the same three scenarios—actual sequence, returns received in order of best to worst and returns received in order of worst to best—with retirement withdrawals factored in. A withdrawal rate equal to 4% of the initial portfolio balance, adjusted each year for inflation, is used.
Under the actual returns scenario, the retiree maintained a considerable amount of wealth relative to his or her savings at the start of retirement. The portfolio benefited by having the bad years dispersed throughout the time period. This dispersion allowed the portfolio to recover from the post-tech bubble (April 2000 through February 2003) and the financial crisis (November 2007 through February 2009) bear markets.
The best-to-worst scenario was also favorable for the retiree. The biggest gains in the equity markets coincided with the years the withdrawals were the smallest. This allowed the portfolio to take advantage of the big up years and grow considerably. The resulting gains were large enough to carry the portfolio through the big down years late in the scenario.
Conversely, the worst-to-best scenario left the retiree with an ending portfolio value of approximately $8,700. Assuming withdrawals would continue to be increased with the rate of inflation, the portfolio would be completely drained in less than two additional years beyond the period used in the scenario—a disaster for a retiree with late-in-life expenses. It is the scenario that is the basis of the logic to make a portfolio more conservative as an investor ages.
Two simultaneous events coincided to wreck the portfolio under the worst-to-best scenario. The first is the span of five consecutive years with falling stock prices at the start of the scenario. These drops occurred when the allocation to stocks, in dollar terms, was at its largest. The second was the stream of withdrawals. The retiree increased the withdrawal amount at the same time that the portfolio was experiencing big drops in value. By the time the stock market’s returns reached positive double-digit percentages, the damage to the portfolio was done. The stock allocation was wiped out, leaving the portfolio completely dependent on its bond allocation.
What can you do if faced with bad returns early in your retirement?
You can affect how your portfolio evolves by taking various actions. Even a simple strategy of rebalancing the portfolio can have a positive impact under the worst-to-best scenario.
In this example, were the retiree to adjust the portfolio back to the 60/40 allocation at the end of every year, the ending value would rise from $8,700 to $92,000 under the worst-to-best scenario. Assuming inflation stays near its historical average of 2.9% and even modest positive returns in the future, this balance should be sufficient to prevent longevity risk from being incurred.
There are, of course, other levers that can be pulled. A variable withdrawal rate would help by reducing the withdrawal amounts during the bad years. Such a step could prove to be difficult to do in practice, especially if it reduces the amount of retirement income too severely. You could seek out alternative sources of income, such as working part- or full-time, or tapping your home equity by downsizing, moving to a cheaper area and/or taking out a reverse mortgage. None of these may be ideal, but they could greatly reduce longevity risk in a scenario of bad returns early in your retirement.
Another option is to alter your portfolio’s allocation before retiring. This could, for example, mean changing to a bucket-type approach, which segments the portfolio based on when funds will be needed. Money needed for the first few years of retirement could be allocated to cash or other short-term investments, allowing you to skip taking withdrawals from the long-term stock/bond allocation during the difficult early years of a worst-to-best scenario.
You could also go very conservative at retirement and then either gradually or aggressively increase the equity allocation once in retirement. This would allow your portfolio to effectively buy stocks on the cheap while avoiding much of the initial damage. A tactical approach could also be followed to limit the damage of a bad early sequence of returns, though this can be very risky if the decision to get back into the market is not made at the right time.
Be aware that the best-to-worst and worst-to-best scenarios are hypothetical. Though using actual return data, the sequence of returns in these scenarios reflects what could have potentially happened, not what did or will possibly happen. These scenarios are useful for demonstrating how a given sequence of returns affects a portfolio, but may not have any relation to the returns realized by stocks or bonds in the future.
Long-term data should ease some worries about a potentially lengthy period of negative returns. The 2014 the Ibbotson SBBI Classic Yearbook does not show a single 20-year period where the return for a portfolio of either 70% large-cap stocks/30% long-term government bonds or 50% stocks/50% bonds was negative.
Since the long-term sequence of returns cannot be predicted, investors should pay attention to the historical odds and incorporate strategies designed to handle the volatility of the market. This means not only adhering to an appropriate long-term allocation, but also taking periodic (e.g., annual) actions to ensure the portfolio does not drift too far from its allocation targets. Investors should also incorporate flexibility into their financial plans, including budgeting for variability in withdrawal rates.
Finally, keep in mind that the allocations discussed here only used a large-cap stock fund and a total bond market fund in the examples. Annuities, bond ladders, one-to-five years of cash savings and other assets can also be used to help mitigate the risk of a negative sequence of returns for any specific asset class.
The big keys are to stay disciplined, never panic and realize that even in the worst-case scenario, there may be more than one action that can be taken to lessen the financial damage.
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