One of the biggest risks you will face in retirement is making sure you don’t run out of money. Every industry has their own set of jargon, and in my industry we call this “longevity risk.”
It’s the risk that your money runs out before you do.
And in reality what would typically happen is that as your money gets closer to running out, you would cut back your living expenses and spending habits in retirement. You would sacrifice and not live the retirement that you always wanted.
There’s even some industry jargon for that event: “consumption discontinuity.”
How’s that for obfuscating the idea that’s trying to be communicated. I couldn’t make this stuff up.
A critical component of most people’s retirement plan is that they need their assets to grow to help offset the effects of inflation. And they also need their assets to grow to help support their spending requirements that are reducing their portfolio’s value with each withdrawal.
Many people expect that if they invested their portfolio in the market they could get around 8% annualized growth. And many people think that would be enough.
But today I’m going to show you an example of when 8% isn’t enough to sustain your spending requirements in retirement.
8% Growth On My Portfolio Is Not Enough!!??
Let me first say, “Well, 8% could be enough growth to sustain you in retirement. It all depends.”
So what does it depend on? Let’s look at a hypothetical situation to answer that question.
In this screen shot from an Excel spreadsheet I made, I show a portfolio that starts out at $500,000.
Withdrawals from this portfolio will be based on 5% of the starting balance. Therefore, the first year withdrawal would be $25,000 ($500K x 5% = $25,000).
The withdrawals each year thereafter will increase by the inflation rate, which I assume to be 3%.
And if you take the growth rates on the portfolio for all these 20 years, add them up and divide that number by 20, you get an average growth rate of 8%.
Here’s the screenshot:
As you can see, the portfolio did fine. The owner was able to begin at a 5% withdrawal, which was $25,000. Then was able to increase the withdrawals to keep up with inflation each year. The portfolio had average growth over the 20 years of 8%.
Ending portfolio value was $1,125,599!
Not bad. It ended with more than it began with.
But Sometimes 8% Growth Is Not Enough!
Now let’s take those same returns, and let’s reverse the order of those returns. So instead of starting out with strong growth in the first year of 22.20%, we will instead take the losses up front. In the first year in this scenario the portfolio lost -16.50%.
Here are the results showing the returns in reverse sequence:
As you can see the portfolio this time ran out of money. In year 20 the balance was -$16,618.
So what happened?
The portfolio had the same average 8% growth. It had the same withdrawals, starting out at 5% and increasing with inflation each year thereafter. Why did it not perform as well under this scenario?
And the answer has to do with the order in which the portfolio realized its returns.
In a nutshell, the second scenario showed the portfolio taking some large losses up front. The first 3 years showed the following losses:
- Year 1 -16.50%
- Year 2 -13.10%
- Year 3 -5.90%
These losses were occurring while at the same time withdrawals were being made to supplement the owner’s income.
The dual effect of this was too much for the portfolio to handle. It was not able to recover and be able to last for over 20 years.
By the time the stronger growth rates came along in later years, there wasn’t enough of a balance left in the portfolio to give it enough growth.
The Order Of Your Returns Is Important
The hypothetical illustration shows you the importance of the order of your portfolio’s returns. There is even a phrase for this in the industry: sequence of returns risk.
So many insider phrases, so little time!
But in a nutshell it means that if you have a lot of poor performance out of your portfolio in the early years of retirement you are more likely to run out of money. If you have stronger performance in the early years you have a better chance of not running out of money.
What Is The Solution To This Risk?
The solution is to reduce the uncertainty in your portfolio.
Let me illustrate what I mean by uncertainty. If you could go to the bank and purchase a CD that would guarantee to pay you 8%, what would the uncertainty (or volatility) of that investment look like?
Answer: there would be no volatility (or uncertainty).
You would know each year that you are getting 8% on your invested principal.
You wouldn’t have to worry about having those big negative years of losing 22% on the portfolio, while making withdrawals. CD’s don’t go down if the market crashes. It’s in the contract the amount of growth (interest income) you will get. And it’s in the contract that they won’t lose value.
When it comes to your portfolio, returns and growth are important. But reducing volatility and uncertainty are important as well.
For example, we can take the S&P 500 average annual return since its inception in 1928 up to 2014 and know that it was approximately 10%.
That’s great growth. But there are years in there where it can grow fantastically, and there are years when it can drop by a lot.
If you retired at the beginning of 2008, and you had your portfolio all in the S&P 500 (because you thought that was diversification) then you were about to experience a large decline in your portfolio. At the beginning of 2008 the S&P 500 stood at about 1411. It dropped to 931 by the beginning of 2009. That’s a drop of 34%.
It dropped further to 683 in March of 2009. From 1411 to 683 that’s a drop of 51.5%.
Of course it needs to be said that the S&P 500 rebounded and was back to 2008 highs by 2011. And it has since gone on to exceed those highs as of the writing of this article.
But if you had just retired, and you were relying on your investments to support your spending requirements in retirement, your withdrawals during that time would further push down the value of your portfolio.
And that’s why some people had to re-enter the work force after 2008. And even more people had to delay retirement after their portfolios took a big hit that year.
So although we can look back and see the average annual growth of this investment, the S&P 500, to be approximately 10%, it doesn’t tell the whole story. It doesn’t account for the risk of volatility and how that can affect your retirement.
Here are a couple of options to reduce volatility, and hence uncertainty, in your portfolio.
#1: You can introduce more conservative components into it. This may include using bonds funds in your portfolio.
Sure, they typically won’t have as much growth potential as equity based investments, but they will generally be less volatile.
#2: Another option is to use fixed annuities. A fixed index annuity is specifically designed to not go down when the market goes down. And when the market goes up it will participate in some of the upside.
Having a portion of your portfolio that cannot lose value is a great way to reduce volatility.
A fixed annuity is a good tool for making withdrawals from savings to supplement your retirement income. You never have to worry about withdrawing from it after the market has depressed its value. By its very nature its value will not decline due to market downturns.
#3: And another option is to be tactical with your investments. If you have a plan in place that is based on rules (not emotions), and then stick to the plan through thick and thin, it can help you reduce volatility in your portfolio.
I discuss this here in my 3-part video series: “6 Ways The Wealthy Manage Their Investments That Ordinary Investors Do Not.”
The alternative to tactical investing is a buy-and-hold strategy. A buy and hold strategy is where you ride the market all the way up… and all the way down. A tactical strategy allows you to trade, based on a set of rules, so that you don’t ride the market all the way down.
During a rising market, like in the 1980’s and 1990’s, buy and hold can work very well. During markets like we’ve experienced from 2000 and onward, being tactical may make more sense.
Don’t Just Consider Returns On Your Portfolio
There are actions you can take to reduce the volatility in your portfolio. An annuity, for a portion of your portfolio, may be a part of that plan. Or just being more tactical with your investments, as I discuss in my 3 part investing series, may be the option you choose.
But at the least, if you are wondering, “Do I have enough to retire?” be sure to take into consideration the growth that you need AND the effects volatility can have on your portfolio.
It turns out the order in which you get your returns plays a big part. And that also means that if you can reduce the volatility in your retirement portfolio, you will have a higher chance of meeting your retirement goals and not running out of money.
If you know someone that is struggling with how to invest their retirement portfolio, please forward this article / video to them. It could seriously help them make a better decision.
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