By: Krisna Patel, CFA
The thing that surprises me most about my wife’s catering business is how much food is usually leftover. I often ask, “is there a better way to manage food costs,” and her answer is always the same, “better to have food leftover than fall short.” She has exceptional ability to estimate the amount of food each person will eat, but she can never be absolutely sure how many people will come and how much they will eat.
When planning for retirement, we also “don’t want to fall short.” To make sure we don’t, we must account for a multitude of factors, e.g.
- How much income do I need?
- How long will I need the income?
- What will inflation be like?
- How much do I want to leave for beneficiaries?
Answering these questions can be a daunting task and one that a plethora of financial applications try to model. However, no matter how good we are at answering these questions, there is one question that is almost impossible to answer ahead of time. The sequence of investment returns we receive in retirement is one of the most important factors in determining retirement success. Unfortunately, the sequence is almost impossible to determine ex-ante.
Simply stated, sequence of returns is the order in which returns are realized. When we accumulate assets, the sequence of returns is of little consequence. To illustrate the point, let’s say you start out with $100,000 invested in stocks. In scenario 1, you experience negative returns at the beginning of your investment horizon, whereas in scenario 2 we flip the sequence so that the negative returns are at the end of the horizon.
For illustrative purposes only, not indicative of any specific investment product.
We can see that irrespective of which sequence we realize; the ending value is the same, with the average return in both scenarios being 6.05%. As we enter retirement, we must now account for distributions, effectively changing the math. Using the same returns, we now account for a real income distribution of $50,000/yr.1 from a starting nest egg of $1,000,000.
For illustrative purposes only, not indicative of any specific investment product.
The “average” return in both scenarios is the same, but now with vastly different outcomes. If we experience the negative returns upfront (Scenario 1) we run out of money, a devastating situation in retirement. However, simply flipping the sequence (Scenario 2) grows our nest egg to $1.6M, begging the question “did we maximize income?” The situation reflects the sequence of returns risk (SoRR) in retirement; the order of returns is more determinant than the “average” return. SoRR, longevity risk, and unexpected expenses are substantial factors in affecting a successful retirement. To address these factors a variety of strategies have been developed. Generally, they fall into one of five categories, each with its own merits and shortcomings: Certainty, Static, Bucket, Variable, and Insuring.
The Certainty strategy:
One strategy is to simply use a model that many institutions employ to fund their future liabilities, known as Asset-liability management (ALM). Simply speaking, you invest money today in a manner designed to meet a future liability with a high degree of certainty. For example, let’s assume one year from now we want to cover $50,000 in income, and the current interest rate environment is 3%. Assuming the interest rate and principal are guaranteed we could invest $48,545 ($50,000/1.03) today to meet that future obligation. However, this will not protect you from inflation. Alternatively, we could take $50,000 today and invest that into a one-year US Treasury Inflation Protected (TIP) bond, thus covering the liability while also protecting it from inflation risk. For all its certainty there are some drawbacks to this strategy. To make sure we don’t run out of money we would need to determine how many years to fund, an almost impossible task without having the foresight of our demise. Additionally, the strategy requires a very large upfront capital commitment, something most Americans are unable to accomplish.
The Static strategy:
If retirees lack the capital to fund the ALM strategy or simply are unable to calculate the duration of retirement an alternative approach is to calculate a “safe” portfolio withdrawal rate. The seminal paper that discussed this strategy was William Bengen’s Determining Withdrawal Rates Using Historical Data.2 Using historical returns on a 50% stock/50% bond portfolio he determined the optimal starting withdrawal rate to be 4%. Therefore, to sustain a real income of $50,000/year you would need a starting nest egg of $1,250,000. Every year thereafter, you would adjust the previous year’s withdrawal for inflation. As with any retirement income strategy, there are assumptions involved. In this case, Bengen assumed a 30-year retirement horizon and an annual rebalance back to the 50/50 portfolio. The challenge for retirees is rebalancing back into stocks after a large drawdown, due to loss aversion, potentially derailing the strategy. Bengen’s “4%” withdrawal has been re-evaluated in follow-up papers and thus far has been shown to be an effective retirement strategy. However, with current elevated stock market valuations and low bond yields, some have recommended a slightly lower starting withdrawal rate.3
The Bucket strategy:
To overcome the fear of rebalancing in a down market, retirees may prefer to deploy a bucket strategy. The strategy exploits the cognitive bias of mental accounting, our tendency to assign subjective values to different buckets of money (think Christmas account) regardless of fungibility. To implement the strategy investors establish two (or more) buckets:
1) A cash like “short-term” bucket funded with 2-3 years of income needs.
2) A “long-term” diversified investment bucket with remaining retirement funds.
Retirees then pull income needs, year to year, from the short-term bucket. The long-term bucket then replenishes the short-term bucket over specified intervals or balance thresholds. While this strategy will not eliminate the sequence of returns risk, it may allow retirees the flexibility to navigate market downturns. In an effort to mitigate losses, bear markets often compel retirees to rebalance to a more conservative allocation. Unfortunately, this will reduce the chance of recovering losses realized and/or increase future income. By physically and mentally segregating the buckets, retirees may be less prone to make irrational decisions; understanding current income will not be affected by market downturns while at the same time allowing the long-term bucket time to recover.
The Variable strategy:
Most static retirement income programs simply adjust your income distribution by inflation, keeping your real income the same regardless of need. But what if income needs change year-to-year? In data collected by Morningstar Investment Management, David Blanchett noticed spending doesn’t stay the same through retirement and referred to the pattern as a “retirement spending smile.”4 He noted that spending is higher in the beginning years, declines through the middling years, and then starts to rise near the back end of the horizon. Intuitively a phased spending scenario makes sense. Retirees will typically spend most of their consumption and entertainment upfront, gradually reducing expenditures as health and mobility decline. The increase in spending near the end of retirement is attributed to health care expenses that by in large become a greater portion of spending. With this in mind, a retiree may deploy a variable spending schedule for retirement income. The most basic form would be to plan a higher initial income that gradually decreases over time while also accounting for future health care needs. This will typically yield a higher initial income but comes at the expense of some behavioral biases. Humans tend to be creatures of habit and accepting a lower income when the time comes presents a challenge for most. Additionally, it’s difficult ahead of time to model out just how much income reduction to plan for. Various retirement income models try to estimate this “retirement spending smile,” but when faced with the reality of a reduced income, follow-through becomes the hurdle.
The Dynamic strategy:
While a variable income strategy will typically layout phases to income, a dynamic strategy will adjust according to market conditions. One form of dynamic income planning uses Monte Carlo* analysis. A Monte Carlo simulation runs 100s, if not 1000s of possible capital market scenarios to determine the probability of distribution success. Retirees then increase or decrease income based on the level of probability determined to be satisfactory. For example, if 85% is deemed a successful threshold and the Monte Carlo calculates 95% distribution success, the distribution could be increased. Alternatively, if the Monty Carlo simulates a 75% probability, distributions would need to be decreased. A success rate of 100% is ideal, but undoubtedly there will be circumstances in which that is not possible and therefore the biggest hurdle to the strategy is determining what level of confidence is satisfactory. Once you have determined the acceptable threshold, you can run the Monte Carlo at pre-defined intervals (annually, bi-annually, etc.) to increase or decrease income. As in the variable income option, it assumes that a retiree is willing and able to moderate income in the positive AND negative direction.
The Insuring strategy:
Ultimately, the retirement nest egg is used to generate income and most of the strategies previously discussed require or assume a retirement horizon. Unfortunately, without the benefit of hindsight, we can never be truly sure of the required duration. One way to eliminate longevity risk (the risk of outliving your assets) is by insuring the retirement income stream. In this scenario, a retiree works with an insurance company to provide income over a single or joint lifetime in exchange for a lump sum. To evaluate the strategy, we must balance the comfort of receiving an income regardless of market performance or longevity against the potential costs. Principal accessibility, beneficiary payouts, creditworthiness, and costs are but a few factors to consider.
“Constructing an appropriate strategy is a process, and there is no single right answer. No one approach or retirement income product works best for everyone.” – Murguia and Phau5
The strategies outlined are not exhaustive, and simply a framework retirees can use to understand different approaches. Which strategy, or strategies, to employ will be a function of personal preferences and a multitude of variables. For instance, is a retiree more satisfied with a stable or variable income, and if variable, would they prefer higher income now or later? Even if we can answer some of these subjective questions, we can never be sure of the sequence of returns, time horizon, and biases that may derail a particular plan. Ultimately, the retirement plan will require balancing the desires of life, with making sure we “don’t fall short.” A qualified financial advisor may help determine which strategy or strategies best fits these objectives because unfortunately, there is no “one size fits all” approach.
- 2% annual inflation adjustment
* The projections or other information generated by Monte Carlo analysis tools regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary with each use and over time.
Past performance is not a guarantee of future results. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of 01/24/2022, based on the information available at that time, and may change based on market and other conditions. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.
Krisna Patel is an Investment Advisor Representative of Woodbury Financial Services, Inc., at 11001 W. 120th Ave. Suite 400, Broomfield, CO 80021
Krisna may be reached by phone at (317)489-3505 or by email at email@example.com
Securities and investment advisory services offered through Woodbury Financial Services, Inc. (WFS), member FINRA/SIPC. WFS is separately owned and other entities and/or marketing names, products or services referenced here are independent of WFS.