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Retirement Planning for the Unwealthy

Sequence of Returns Risk: What's That Mean


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.)





[Image: Screen+Shot+2013-09-30+at+12.52.25+PM.png]

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.
 
 
 
 NB:-

So this is recommended for

"Retirement Planning for the Unwealthy
."

If you are wealthy, what sort of plan then?

How to to allot your assets to generate cash flow to meet your yearly expenses?

And maybe still left over some to increase your portfolio value though you are in your "spending phase".
Hi Temperament

Usually the wealthy won't be worried about their retirement cashflow but more worried about their estate planning Smile

Constant dollar averaging is good strategy for man on the street investing, but bad idea for withdrawals. Like we always say in VB: It is possible to drown in an average 1.5m pool Smile

Difference between equity vs bond is the terminal value and uncertain time horizon. That's why I always maintain that timing on a longer trend basis is important for equity investment.
Hi specuvestor,

"That's why I always maintain that timing on a longer trend basis is important for equity investment."

//////////


Completely agree to the above.

To me it means SOR should not applied or very little if we can "control" the time factor.

The only thing/problem then which stocks in which market or Index to buy for 30 years or more?

Me?

i have and still is interested in stocks in Singapore market only.

i happen to have HEWLETT PACKARD and BAC shares on DRIP since 1985 or so.

Because i was with HP and my wife was with Bank Of America.

We don't make much money on US stocks partly due to Exchange Rate from about $2.5 to now $1.41 to 1 US $.

This makes me wary of investing in other markets for long term.
You can "control" the time factor if you are not forced to sell, assuming the stock pick is reasonable. The article is referring to "forced to sell" because of retirement.

Another example is funds for Marriage or Study are instances whereby one may be "forced to sell" because there is a relative fixed time to consume the saving, so in general those should not be heavily tilted towards equity. The rule of thumb is to hold bonds % that are equal your age: example is you are 40, then hold 40% bonds 60% equities.

Again this is all generalisation. At its core it's a matter of managing cashflow. For example if you have substantial bonds that mature when you are 60-70 then you can hold a high % of equities that you can CHOOSE to liquidate between those 10 years, even if say you are already 60 and retiring. The killer is always when "forced to sell", including margin calls or burden by debt even after retiring, when your capacity for loan drops. Having say conservative 90% bonds allocation that mature when you are 70 is not going to help when you need cash now, and again forced to sell either bonds or equities.
Actually, for the average man on the street, if we had invested enough (time, love and attention) with our loved ones (be it children, friends or relatives) when we were younger and capable, i think that is good enough "insurance" to hedge against this SOR risk. We may outlive money, something very tangible but we will not outlive the intangible.

At of the day, as Charlie Munger like to say, we will get what we deserve.
A person of modest means who relies on the stock market only to fund his retirement is a bit of a fool.

You should secure a basic income using a relatively sure means. Then anything over and above that is gravy. Which is why annuities have a part to play. For myself, I plan to maximise my CPF LIFE when the time comes and even buy an additional private annuity to supplement that. I plan to use stocks only to pay for my non-essential stuff like travel etc.

Once you secure your basic income, you are a lot freer to take on risk. Also a lot freer to actually retire without retirement adequacy praying on your mind.

To those who say annuities provide paltry return, you are missing the point. Annuities are not really primarily investment vehicles. They are primarily longevity risk products. In return for a life long income, you give up the right to your premium should you die early. If you don't die early, you effectively gain someone else's premium. That's why its call risk pooling.
Annuity for life?

There is  a "self -designed" perpetual immediate Annuity for life where the principle is intact for life if you just withdraw the the annual interest generated at every DEC.

Some people has been blogging about this type of Annuity for life in Singapore Investment Bloggers.

If you have about a $million there, the interest which can be withdrawn at every DEC is about $35,000 + - without touching the principle.

Next year, should be the same until the goal post is shifted again.

And if the market crash, you can withdraw some of the principal for fire-sale in the stock market.

What annuity or bond can beat this "self-make" annuity?
(09-02-2017, 09:27 PM)weijian Wrote: [ -> ]Actually, for the average man on the street, if we had invested enough (time, love and attention) with our loved ones (be it children, friends or relatives) when we were younger and capable, i think that is good enough "insurance" to hedge against this SOR risk. We may outlive money, something very tangible but we will not outlive the intangible.

At of the day, as Charlie Munger like to say, we will get what we deserve.

Yes, at the end of our day, no matter how much money you have, is of very little use.

This reminds me of the picture of Stanley Ho on wheel chair and the people left around him that matters more than anything he has.

But how SOR is related to taking care of our loved ones comparable to financial investing/management?
(09-02-2017, 10:30 PM)Temperament Wrote: [ -> ]Annuity for life?

There is  a "self -designed" perpetual immediate Annuity for life where the principle is intact for life if you just withdraw the the annual interest generated at every DEC.

Some people has been blogging about this type of Annuity for life in Singapore Investment Bloggers.

If you have about a $million there, the interest which can be withdrawn at every DEC is about $35,000 + - without touching the principle.

Next year, should be the same until the goal post is shifted again.

And if the market crash, you can withdraw some of the principal for fire-sale in the stock market.

What annuity or bond can beat this "self-make" annuity?

haha! Big Grin

CPF!! Tongue  

Also know that the wealthy ones has top up all their newborns-childrens's OA/SA to maximum to enjoy this CPF!! Big Grin

smart money at work! Tongue
(10-02-2017, 10:14 AM)Temperament Wrote: [ -> ]
(09-02-2017, 09:27 PM)weijian Wrote: [ -> ]Actually, for the average man on the street, if we had invested enough (time, love and attention) with our loved ones (be it children, friends or relatives) when we were younger and capable, i think that is good enough "insurance" to hedge against this SOR risk. We may outlive money, something very tangible but we will not outlive the intangible.

At of the day, as Charlie Munger like to say, we will get what we deserve.

Yes, at the end of our day, no matter how much money you have, is of very little use.

This reminds me of the picture of Stanley Ho on wheel chair and the people left around him that matters more than anything he has.

But how SOR is related to taking care of our loved ones comparable to financial investing/management?

SOR is layman terms, is the risk of outliving our money, despite investing it, right? So, if one look at life holistically and have "invested" in family and relationships earlier in their lives, there should be someone (younger with earning power) whom will reciprocate the "investment". So, one may outlive their own money, but hopefully if done right earlier in their lives, they will be able to then depend on the relationships they built up.


P.S. The stanley ho's picture still strikes a deep chord in my heart too.
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