The Impact of Retirement Distributions in Volatile Markets

Over the last fifteen years in the financial planning field, the most commonly expressed concern I have heard from a retiree/pending retiree has been…Will I run out of money ??? When examining this question there are many variables to be concerned with such as inflation risk, principal risk, interest rate risk and changes to lifestyle in retirement. However the most important risk that is all too often neglected by a retiree is what we refer to as the risk of a negative sequence in a withdrawl strategy.

What is a negative sequence ??? A negative sequence is a risk that refers to the difference between average returns on an investment and the sequence of returns. This is a vital concern for a retiree whom depends on their portfolio for at least a portion of their retirement income. All too often investors confuse their average return with what they can reasonably expect to draw from an investment strategy. An example of such a risk is easily examined by looking at some fairly basic arithmetic. An investor retiring at a traditional age 65 with a portfolio comprised of 50% in stocks and 50% in fixed income investments would note that their average return over a 30 year period would be approximately 8% per annum. Even over the last decade of subpar returns, they would have likely achieved close to a 6% annualized return with a disciplined investment strategy of such an allocation.

So does this mean that should we average 6-8% per year that we may then spend 6-8% per year ??? The answer is most likely NO. When examining two investors whom are accumulating a savings with the same average return over any number of years, the results are the same. However when we look at withdrawal strategies, the facts are quite different. In simple terms, if you assume an 8% return, you will not likely achieve 8% in each of the following 30 years of your retirement. It is far more likely that you would see a fairly random set of performance numbers that more likely average 8%. What if the first year your portfolio declined by a value of -10% ??? In a year such as 2002 or 2008 this is certainly quite possible. Simultaneously you have opted to take a withdrawal of 7% from your asset base. By doing some simple math, we can see that you have a real decline in your asset base of -17% your first year of retirement. The below illustration provides a closer look at how simply changing the order in which returns occur, there can be a substantially different outcome.

THE SAME AVERAGE RETURN… BUT IN REVERSE ORDER

THIS IS A HYPOTHETICAL EXAMPLE FOR ILLUSTRATIVE PURPOSES ONLY AND DOES NOT REPRESENT ANY SPECIFIC INVESTMENT.

Note: $100,000 is invested into each of two hypothetical portfolios at the start of year one. Portfolio B earns the same returns as Portfolio A, but in a reversed sequence. $7,000 is withdrawn at the start of year one from each portfolio. Portfolio A runs out of money in year 13, while Portfolio B ends up with a larger balance than inception.

So how can we protect against this risk ??? While no approach can be presumed to be flawless, there is one glaring mistake in the above example. The hypothetical investor is attempting to begin a withdrawal strategy at 7% per annum. While as we can see this is not impossible, it does require a substantially positive portfolio outcome early. Since that is not something we can assume to be dependable, we must then lower our withdrawal assumptions. A generally accepted withdrawal rate in the early stages of retirement is considered to be closer to 4-4.5%. Any attempt to withdrawal greater than this will potentially provide great stress on a financial plan and risk the possibility of a positive outcome. Additionally such a withdrawal rate is typically premised on maintaining close to a 50-60% exposure to equities in a portfolio. Clients whom take a more conservative stance should then assume a more conservative corresponding withdrawal strategy.

A 2009 study published in the Journal for Financial Planning concluded the following probabilities in relation to a portfolio that maintained a constant allocation of 60% in equities and 40% in fixed income investments. The probability of depleting all assets over a 30 year period with a 4% withdrawal rate was less the 5%.

As always, it is important to look at each investors circumstance as unique, based on varying factors such as age and lifestyle needs. Many different factors around withdrawal strategies may alter ones allocation or expectation of success. It is important to look at your specific financial profile when determining a withdrawal strategy.