San Francisco Financial Planner, San Francisco Financial Advisor

Getting off on the right foot is nowhere more important than in retirement.  This is true in general, but especially about portfolio returns.  The better the portfolio returns in the early years of retirement, the better the chance of having the picture book retirement scenario we all strive to create.   If this is so, why do so many portfolio illustrations use an average rate of return of 8%?  Not nearly enough information for retirement income planning purposes.  How do portfolio projections differ before and after retirement and what are the factors that impact portfolio sustainability?  A quick look at these issues can give a better understanding of recommendations for withdrawal rates, multi-tiered income strategies and other retirement funding techniques that can be utilized to secure reliable retirement income.

There has yet to be a period of time where the market consistently returned 8% per annum.  But the popularity of using 8% average rate of return for financial illustrations is very common.  These simple projections are adequate for pre-retirement portfolios as the fluctuations in returns have less impact during the accumulation phase.  Ideally, with regular contributions and average market returns the portfolio will grow because it only has to contend with fees and tax expenses.  The added burden of withdrawals that begin upon retirement is the major differentiating factor on portfolio performance.   Contrary to the accumulation phase, once withdrawals are added to the mix, the timing of the returns becomes dramatically more important.  To understand why, an explanation of the components used in retirement income simulations will be helpful.  Retirement income simulations have at least four components:

• Starting portfolio value
• Withdrawal rate
• Inflation rate
• Rate of return

Starting Value

The starting portfolio value is the variable that the rate of return is based upon.  The greater the starting value, the greater the actual dollar value of return will be.  The impact of good returns at the outset will increase the size of the portfolio throughout the portfolio’s entire time horizon.  If the starting value of the portfolio diminishes at the beginning of the retirement phase, the actual dollar value of returns will diminish proportionally.  As the old adage goes: “It takes money to make money.”  

Withdrawal Rate

The amount of money withdrawn from a portfolio as a percentage of the portfolio’s starting value is the withdrawal rate.  Extensive back-testing has shown that a withdrawal rate of 4%-4.5% can be withdrawn with a high degree of confidence that a portfolio can be sustained for a 30 year period.  As the withdrawal rate increases beyond this point, the greater the experience of portfolio exhaustion.   In simple terms, “running out of money”.  Thirty years may seem like a long time to expect a portfolio to last, but many people are living well into their nineties and longevity rates continue to climb.  Given these statistics, a 30 year time horizon is appropriate for planning purposes.

Inflation Rate

Inflation plays a part in two aspects of retirement income projections.  First, the withdrawal rate is usually adjusted for inflation based upon your first year’s withdrawal amount.  If your first year’s withdrawal is $50,000, to have the same relative standard of living, the second year’s withdrawal amount would have to increase by the inflation rate. At a 3% inflation rate, the following year’s withdrawal would by $51,500. The actual dollar withdrawal increases by the inflation rate throughout the retirement period.

Rate of Return

Inflation is also a component in the rate of return that the portfolio is expected to earn.  The difference between the total return, or nominal return and the inflation rate is the real rate of return.  The real rate of return is what truly matters, as a total rate of return that does not outpace inflation will decrease the purchasing power of your portfolio. 

Numbers Never Lie - Most of the Time

Take this for example.  How would you explain the difference between these yields?

8%, -11%, 14%  versus  -11%, 14%, 8%

What would be your response?  Most would pause for fear of a looming trick. The numbers are exactly the same, merely in a different order.  The sequence doesn’t matter, or does it?  Over time, oscillating returns combined with retirement withdrawals can have an amazing effect on liquidity and how long your portfolio will last.

All things being equal, investment returns drive a portfolio’s growth.  Consistently contributing untouched money into the market can result in outpacing inflation, and nest egg construction. During the accumulation phase, the order in which returns are achieved have no mathematical impact on the total accumulation.  Yet, this same market ebb and flow during retirement can result in a devastating blow.

The sequence of returns refers to the chronology of when the market bestows positive and negative returns into your portfolio.  A portfolio’s fall in value during the accumulation stage has little financial impact to the lifestyle of an investor, as they would not be taking current income from the portfolio.  But, if the same sequence of declining returns occurs in retirement years, the income available to be spent on an ongoing basis stands to be substantially less.
 
A Perfectly Random Storm

Let’s say an investor takes a 5% annual distribution during retirement when the market has his portfolio down -15%.  This can result in a storm of negative compounding. If in the very next year, the market is again down -10% he is now taking a 5% distribution from a smaller pool. One can see how quickly money that took 30 years to grow can evaporate in half the time.

Another way to look at it is to assume an investor had a portfolio value of $1 million the year prior to retirement.  She assumed that she could spend 5-6% per annum or $50,000-60,000.  What if in the first year of her retirement the market declines by 20%?  There would be enormous dilution to her pool of funds.  Her portfolio would decline to $800,000.  The next yearly distribution of 5-6% would only generate $40,000-45,000 from the same portfolio.  Not only would the income received be reduced, the amount remaining in the portfolio would be less, ultimately affecting the sustainability of those assets throughout retirement.  The probability of the portfolio running out of funds too early would increase dramatically.

Future Signs

There are several factors that can affect a portfolio’s performance during its accumulation stage, including:

Willingness to Save - The percentage of an individual’s income they are willing to save on an ongoing basis will dramatically affect portfolio value at retirement. The more wealth accumulated, the less the sequence of returns will impact the portfolio’s future value and income producing activity during retirement years. The more hay in the barrel, the less you notice when a few straws are lost.

Staying Invested - For long-term investing, the general rule of thumb is to get invested and to stay invested. The more an investor moves in and out of their security holdings, the greater the risk for portfolio loss, and the impact the sequence of returns may have on its value.

Average Annual Returns - The return that the portfolio achieves annually will drive the portfolio’s overall value, and the impact sequence of returns may have on it. One must stay invested in order to achieve sufficient accumulation over the years.

Asset Allocation - The diversification and strategy that is used during portfolio accumulation can help to buffer the portfolio’s value from the sequence of returns effect.

There are also several factors that can affect a portfolio’s results during the distribution phase:

Security Allocation - The asset allocation should change as an investor gets closer to retirement years.  The ability to shift to a lower volatility strategy will also help to minimize the effects of the sequence of returns on the portfolio’s value.

Risk Tolerance - While it is generally suggested that most investors should become more conservative as they move closer to retirement, not all investors follow suit.  Moving into an asset preservation stage prior to retirement will work to protect the portfolio’s value, and its income producing ability during retirement.

The Last Note

Research magazine in June 2006 published interesting findings from York University professor of finance, Dr. Moshe Milevksy.  He stated, “If there is a bear market, the sustainability of your portfolio will be a lot lower. You won’t be able to make it through retirement with the same level of spending. You’re headed for retirement ruin. The earlier you have bad returns, the  worse it’s going to be for your retirement.  So, for the first few years, you need to protect your portfolio.”

To Conclude

For pre-retirement (or “accumulation”) portfolios, an average rate of return can demonstrate how the portfolio will grow over time.  However an average rate of return can not accurately predict the length of time a portfolio will survive in retirement due to the impact of withdrawals and the sequence of returns has on the life of a portfolio.

Given these parameters, retirement income planning needs to be tailored to each individual investor, as income sources and needs can vary widely.  Many options can be used and combined in various proportions that include; a guaranteed income stream for life, cash flow generating assets and portfolio protection strategies.  If for example, if an investor does not have any pension benefits, a portion of the portfolio may be annuitized to ensure a minimum income stream throughout retirement.  Cash flow generating assets that provide interest, dividends or rent can contribute to retirement income reducing the need to draw down principal.  Finally, portfolio protection can come by the way of modifying withdrawal rates in response to less than anticipated returns and the use of a non volatile, two year income fund that enables an investor to avoid drawing down a portfolio in years when returns are poor. 

If you are in or near retirement, an independent financial planner can perform the necessary analysis of your specific situation and recommend strategies suitable for your retirement goals.  Please do not hesitate to contact our firm to discuss proper retirement income planning.  Developing and executing disciplined investment strategies during retirement can work to protect your portfolio from the potentially negative effects of the sequence of investment returns.