Understating Sequence of Return Risk

[hnzw_rui]

I still dont believe sequence of returns affected your returns enough to lower your avg return to 2.5%. You must've made some moves at the wrong time. I would have to do a lot of research to prove it one way or the other, but if all you did was set your AA in 1987 and then make your contributions thru thick and thin every pay period all the way to 2009, I dont believe you wouldve under performed that badly.

You would've had almost no money invested in the crash of 1987. The other pull backs and corrections along the way were all followed by quick recoveries.

If 2.5% is inflation-adjusted, it's possible particularly if accumulation was done in a relatively short period of time.

 

[utrecht]

If 2.5% is inflation-adjusted, it's possible particularly if accumulation was done in a relatively short period of time.

He didnt say anything about his returns being inflation adjusted. Why would we assume his accumulations happened over a short period of time when he was talking about 1987-2009 a 22 year period?

 

[hnzw_rui]

He didnt say anything about his returns being inflation adjusted. Why would we assume his accumulations happened over a short period of time when he was talking about 1987-2009 a 22 year period?

Missed the period being 1987-2009. Somehow, my reading comprehension goes down when on an iPad. I reckon it's still possible particularly if savings rate ratcheted way up from 2002-2009. Income isn't exactly flat throughout a person's career and those later in their careers probably have higher savings rate compared to gross income than someone just starting out.

Yep, 22 years is relatively short. There are a number of 20-year periods ending on 1974 to 1985 where inflation adjusted rate of return for an 80/20 portfolio is 1-2%. That's a depressing thought.

 

[nun]

Sequence of return risk is important when you have to take income in retirement.....it's also a big risk if you have been dumb enough to buy a variable annuity.

Going into retirement I feel that many people don't adjust their AA enough to mitigate sequence of return risk. This is why I feel that people should have more secure income generators rather than concentrating on equity and some of the riskier bonds. Unfortunately the investments like SPIAs, CDs, I-Bonds etc that could once be relied upon for income are very poor value when you have rock bottom interest rates and not many people have pensions.

I retired back in early 2014 and I have lived off cash and rental income so far. In 2015 I'll start a pension which together with the rental income will cover my spending needs.....so I have zero sequence of return risk no matter what my AA.

 

[daylatedollarshort]

Our plan is to more or less live off SS and pensions. We invest mainly for capital preservation and do not have much of an AA in stocks. Even a zero real return on our portfolio would give us a 2.5% draw down over 40 years if we wanted to spend more than the SS + pension income, and we could do better than a zero real return with a blend of TIPS and I-bonds even at current yields.

So for us we don't see a need to have to invest for more volatility / growth or have to worry about sequence of returns. Plus we bought our house a long time ago and prices and rents have increased in our area, so we have the option to downsize and cash out or rent out the house if we ever need more money. We also have hobby income I don't include in the budget so that is all available for savings or fun stuff.

 

[mathjak107]

Fancy schmancy. The old school rule of thumb was buy low sell high. Always has been and always will be true. Applying various formulas and backtested results really don't have anything to do with the future.
Diversify, make your best guess and hope for the best.

buy low sell high has lost more money for investors then any other mantra.

We thought low was when markets fell 2000 points in 2008 . Who knew it had 4000 more to go triggering stop losses and sending many investors running for the exits.

You see that mantra flys in the face of never try to catch a falling knife.

So what mantra made more money then any other ?

Buy high and sell higher.

An object in motion stays in motion until it hits something. Unless you were the unlucky person who bought the day the trend ends you will make money.

As they say don't fight the trend but the saying buy low sell high does just that since we never know how low is low.

It sounds great in theory but sucks in execution

 

[jkern]

I still dont believe sequence of returns affected your returns enough to lower your avg return to 2.5%. You must've made some moves at the wrong time. I would have to do a lot of research to prove it one way or the other, but if all you did was set your AA in 1987 and then make your contributions thru thick and thin every pay period all the way to 2009, I dont believe you wouldve under performed that badly.

You would've had almost no money invested in the crash of 1987. The other pull backs and corrections along the way were all followed by quick recoveries.

I didn't really make all that many moves. I rebalanced periodically and sometimes changed funds (tried to keep 4 or 5 star ratings), but usually in the same category. Technically, I made one withdrawal in late 94 for about 19,000 (QDRO in a divorce). I kept quarterly records on spreadsheets and tracked the return every year. I never bailed on a downturn if that's what you are referring to. I have a hard time believing it too. I haven't had to make any withdrawals so since 7/1/09 its increased significantly.

 

[jkern]

He didnt say anything about his returns being inflation adjusted. Why would we assume his accumulations happened over a short period of time when he was talking about 1987-2009 a 22 year period?

The accumulations were consistent, generally increasing slightly each year. However, they were about 3 to 4 times larger the last 5 years because I paid off my mortgage in 04. I'm sure that had a effect on my return.

 

[DEC-1982]

I haven't done the math for our situation (I don't have the details) but I am inclined to agree with the OP.

We had a great bull market from 1982-1999 but we had lesser income, more family expenses and less money to put in during that period. From 2000-2015 we had more money to put in but the market has not been as good. I think if our personal money situation had been reversed, more money put in the first stretch and less money put in during the second stretch we would be a lot better off today.

The plus side of it is we made more mistakes early, and they were less costly mistakes because there was less money; we became smarter and settled down to asset allocation and low cost index funds later but not too late.

 

[Senator]

It's also important to note, if you are retiring on a minimal income, with a minimal amount of cushion, that is incredibly more risky than any sequence of returns. Not getting a 50/50 return based on some asset allocation is also more risky. If you cannot match what FireCalc predicted, you may be in trouble.

If we have 15 years of down markets, I suspect that many here would be in trouble. Many will survive, because of various amounts of extra capacity they have. You can reduce your travel budget pretty easily, reducing the rent or property tax budget is more difficult.

 

[retiredunder50]

I like to think in terms of compound annual growth rate versus average annual returns. The various "financial experts" will always tout that the stock market has been returning an average annual return of about 10 percent a year since its inception. Although it is basically accurate, it's a poor number for financial planning. First, consider this short term example: you have $1000 invested in the S&P 500 on 1 January (no additional contributions will be considered as we are concerned about market return effects.) Say the market takes a 40% dive that year (not a crazy number) and your balance is at $600. The next year, everything goes right with the world and the market gains 60% (yes, a crazy number picked to make the point). Your 'average annual return' is (-40% + 60%)/2 = 10% a year -- not bad!!! However, your $1000 balance now stands at $960 after 2 years of 'growth' but you can tell your friends that you are invested in the market that gains 10% a year. Take this to a longer period - say you retired on Jan 1 2000 and you were 100% in the S&P 500 index (the NASDAQ example would be much worse) with your $1000 balance. Let's say you didn't even bother withdrawing the money during that period of time as you were spending down other streams and wanted your balance to grow at the historic 10% average annual return rate. (Note: I am leaving out reinvestment of dividends - it doesn't make that much of a difference). At the end of a 15 year period, the S&P 500 average annual return was actually a little over 6% (not 10%) BUT your actual balance sits at $1869 which is what you would have gotten had you invested in something that had a fixed rate of 4.3% during those 15 years and it was compounded annually. Historic average annual returns don't always translate into ending balance expectations/reality.

 

[utrecht]

But your example, which is extreme, still only results in a difference of 6% return for the pretend market and a 4.3% return for the pretend portfolio. The market returned 40% more than the portfolio

The OP says he got a 2.5% return when the market returned 8.5% over 22 yrs. The market returned 240% of what his portfolio did. I dont believe that can happen with just sequence of returns. Especially after such a long period of time where that stuff has a better chance of evening out.

 

[MichaelB]

Without knowing the savings or portfolio contribution rate over that same period of time we really can't compare the OP's rate of return with any benchmark. This is especially true if the bulk of the contributions were made toward the end of the period.

IIRC, the key to retirement savings is saving more, not getting a higher rate of return.

 

[foxfirev5]

buy low sell high has lost more money for investors then any other mantra.

We thought low was when markets fell 2000 points in 2008 . Who knew it had 4000 more to go triggering stop losses and sending many investors running for the exits.

You see that mantra flys in the face of never try to catch a falling knife.

So what mantra made more money then any other ?

Buy high and sell higher.

An object in motion stays in motion until it hits something. Unless you were the unlucky person who bought the day the trend ends you will make money.

As they say don't fight the trend but the saying buy low sell high does just that since we never know how low is low.

It sounds great in theory but sucks in execution

Good luck. The point I was trying to make is that nobody knows nothin'. Before I make any investment decisions I always ask myself " what do I know that no one else knows?" This has helped keep me on course and avoid many pitfalls. However if I have invested at X and it is now worth X+1 and I sell I will not lose any money. I guess it really doesn't matter anyway since I've been accumulating (index funds) for 35 years and still haven't sold. Next year will be the test as I will be living on interest and dividends.

 

[DJRR]

On the accumulation phase I don't think sequence of returns is significant compared to LBYM and investing regularly.

In 2000 I had ~ $70k
In 2015 I have ~ $600k

During this time the S&P has supposedly been flat and I have invested ~ 10%-15% of my income into retirement.

I invested with a new advisor in 2008 right before the crash. I promptly lost ~ 54% by March 2009. Now, my annualized return since inception of the account is 4.77%, so much more than cash or bonds alone over that time.

Much more worried about the spending phase and losing 50% when I want to stop working. Not really sure how to adjust for that risk. Considering moving few years expenses to cash, immediate annuity, etc. Life expectancy is currently 30+ years, so time for markets to recover but without ongoing investments the impact will be much less.

 

[utrecht]

The easiest way to adjust for that major market downturn risk is to have less money in stocks. SP500 was down about 50% during the 2008-2009 meltdown but Wellington which is 60/40 was "only" down 32%.

My allocation of funds which is also 60/40 in total was only down 28%.

 

[daylatedollarshort]

Much more worried about the spending phase and losing 50% when I want to stop working.

According to the theory of diminishing marginal utility, a loss of 50% hurts much more than a corresponding gain brings pleasure. That may not be true for everyone, but we know that is true for us. We didn't want to have to experience the sick feeling we got in 2008 ever again.

We realized we could have a pleasant and less stressful retirement on what we had saved, our pensions and SS using a liability matching strategy instead a diversification approach. One of my hobbies in retirement has been reading books on the science of happiness and positive psychology. While these ideas may not be true for everyone, many of the suggestions really do fall under the best things in life are free categories. I don't think more money at this point would bring us significantly more happiness, but for us worrying about the stock market every day and potentially losing a big chunk or our savings would make us very sad.

 

[Danmar]

I just thought of a good reason to use an income approach to withdrawals, ie only spend divs. Sequence of return risk is zero if you assume divs don't get reduced. Even if you relax this assumption I would guess the chances of a material div reduction is less than a material market decline. Also, div paying stock is on average less volatile.
So if you are worried about sequence of return risk but don't want to increase your FI allocation, this approach might reduce your risk while keeping the upside?

 

[Options]

The easiest way to adjust for that major market downturn risk is to have less money in stocks. SP500 was down about 50% during the 2008-2009 meltdown but Wellington which is 60/40 was "only" down 32%.

My allocation of funds which is also 60/40 in total was only down 28%.

+1
I changed AA last December to 40/60 knowing I would be retiring this year. I believe it's Dirk Cotton who confirms your point that reducing equities near/just after retirement helps to mitigate SOR. Depending on PF value, I will probably increase AA to perhaps 50/50 in 5-10 years (no, this is not a glide path, as the 50/50 AA would thereafter not be changed).

Along this line of thinking, I am influenced by this thinking:

MutualFunds.com

From the article:

if you’ve reached the point where your personal marginal utility of wealth is low, then your portfolio should be dominated by high-quality fixed-income assets.
As Pascal demonstrated, there are some risks that are just not worth taking. This was a lesson the market taught many investors in 2008.

 

[urn2bfree]

If you believe in the SWR data- whatever number you think is the ”S," and whatever you think the "S" stands for- Safe or Sustainable, AND you believe we have seen the worst (the Great Depression, the stagflation of the 1966-1974 period, the Tech meltdown, the Great Recession,etc.), there is an interesting observation about what you should be able to set your SWR.

It should be "S" to withdraw at a rate based on whatever the PEAK value of your portfolio was- NOT based on the value on the day you retire.
Example:
If you accumulate $1M with a plan to spend $35,000/year and adjust up each year for inflation and on the day after you retire the market tanks-- you should be able to still spend as before and make it 30 years....historically this worst case scenario still works out. But this should be true even if the market tanks the year before you retire and drops your $1M down to $600,000. You should be able to spend $35,000/year and adjust up for inflation even though technically you are spending at a starting rate of 5.8%. That is because the SWR is based on the worst case scenarios in the past when you retire at a portfolio peak and then your portfolio falls. Historical returns are lower after peaks. If it falls before you retire, history suggests historically returns will be better and thus support the higher initial rate. (Really still just the old 3.5% SWR, but as if in year 1 you did not make a withdrawal).

Weird and true and yes, not something with which any of us would likely be comfortable. But interesting.


Sent from my iPad using Early Retirement Forum

 

[RobLJ]

While not exactly on the point of sequence of returns, I looked this morning at the Quicken graph of investment holdings over the last 15 years and noticed that the current portfolio value is almost exactly 10X the value 15 years ago. (I have the data going back to 1995). From 2000 to 2004, the angle of increase is about 25-30 degrees, then afterwards it steepens to close to a 45 degree angle. This is a factor of both increased savings, due to raises and extra retirement, but much of it is the compounding effect. Quicken doesn't provide the overall annual return (like Money used to do), but I'm pretty sure I was lucky to outperform the market, although not over the last 5 years (from 2000 to 2010 definitely).
The 2009 market collapse is noticeable as a pronounced dip, but we were back to the previous peak by September of '09 due to no withdrawals and increased contributions. Retiring then would have been the mother of sequence return hits; the portfolio now is more than double the peak before the Crash. We were lucky in terms of "sequence" in that I would turn 50 in 2008 and so in 2003 or '04 had begun to ponder the implications of this and shift the allocation from 80-90% stocks, to a significantly increased allocation to bond and cash. I also had begun to worry about a housing crash in late '05, so I accelerated what had been a gradual reallocation to bonds/cash in '06 and particularly '07 and moved the majority of bonds to Treasury funds.

In terms of minimizing sequence of returns, I think bonds and cash play a big role here. I have moved to an allocation of a bit more than 3 years in cash and short-term bonds to minimize the impact of a significant correction, although I don't expect an event as severe as 2008. This would be more Treasuries but don't like them intermediate term, so cash and other bonds are higher than usual.

As a result of this compounding effect over the last 10 years, I felt able to semi-retire this year at 57 (working about half-time online), while DW is working online after we moved to Reno two months ago, and we are on a glide path to full retirement. She eventually (or sooner) will change jobs at a much lower payscale, while I can withdraw from the 403b at a 5-6% withdrawal rate if needed, until I draw SS. Also, I consider taking early SS at 62 as an "option" in the event of a stock collapse. Basically, we are on the glide path to full early retirement.

The stock allocation now is 60-66%, and if/as the market goes higher, I will gradually decrease that allocation to 50-55%. (I would accelerate if a bond ladder were available in our tax deferred accounts.) Why play if you are winning the game, as I think Bernstein asks? If interest rates go up, I'll look at annuity, both deferred and immediate, but they are rich priced right now, but a deferred annuity that kicks in at 75 or so might be attractive as and if the cash component grows.

 

[DEC-1982]

If you believe in the SWR data- whatever number you think is the ”S," and whatever you think the "S" stands for- Safe or Sustainable, AND you believe we have seen the worst (the Great Depression, the stagflation of the 1966-1974 period, the Tech meltdown, the Great Recession,etc.), there is an interesting observation about what you should be able to set your SWR.

It should be "S" to withdraw at a rate based on whatever the PEAK value of your portfolio was- NOT based on the value on the day you retire.
Example:
If you accumulate $1M with a plan to spend $35,000/year and adjust up each year for inflation and on the day after you retire the market tanks-- you should be able to still spend as before and make it 30 years....historically this worst case scenario still works out. But this should be true even if the market tanks the year before you retire and drops your $1M down to $600,000. You should be able to spend $35,000/year and adjust up for inflation even though technically you are spending at a starting rate of 5.8%. That is because the SWR is based on the worst case scenarios in the past when you retire at a portfolio peak and then your portfolio falls. Historical returns are lower after peaks. If it falls before you retire, history suggests historically returns will be better and thus support the higher initial rate. (Really still just the old 3.5% SWR, but as if in year 1 you did not make a withdrawal).

Weird and true and yes, not something with which any of us would likely be comfortable. But interesting.


Sent from my iPad using Early Retirement Forum

+1

I think I read a similar analysis in one of the financial books in May. The numbers quoted here are probably not exactly right. It compared two people, one retiring one year with $1M, and the second retiring one year later after a 15% market drop who now has $850 K. It said the $850K person effectively had a higher SWR rate than the $1M person had the year before because the market was lower and therefore future market results would be better.

Although I understand the logic, I personally would still be wary of adjusting SWR using this logic. YMMV.

 

[nun]

Sequence of return risk has only become a common problem since the introduction of DC retirement plans and the increasing direct reliance of people on the returns from equities and bonds. If it is such a potential problem we should be discussing alternative income streams and greatly reducing risk in a portfolio......but you'll have to give up return in most cases.

 

[ERD50]

Sequence of return risk has only become a common problem since the introduction of DC retirement plans and the increasing direct reliance of people on the returns from equities and bonds. ...

I don't really agree - the DB plans just shifted the risk onto the provider - it isn't really a solution, though the pooling might help average things out some over time. But I still don't like relying on a 'promise', I'd much rather have control of my own money.

If it is such a potential problem we should be discussing alternative income streams and greatly reducing risk in a portfolio......but you'll have to give up return in most cases.

Everyone has that option - they can choose whatever AA they feel comfortable with, but just like the typical non-COLA DB plans, inflation can get'cha.

I do think the govt could offer annuities. They could pool the money and the risk, and they don't need to make a profit. They could allow 401K, IRA rollovers etc, maybe some other contributions. But I don't think they should guarantee any specific return, just make payouts based on some reasonable projection. If people start living longer than their actuaries counted on, for example, lower the payments accordingly to keep it solvent. Don't try to get blood from a stone, adapt.

-ERD50

 

[nun]

I don't really agree - the DB plans just shifted the risk onto the provider - it isn't really a solution, though the pooling might help average things out some over time. But I still don't like relying on a 'promise', I'd much rather have control of my own money.

I should have been more specific. Sequence of returns risk was once only a worry for pension funds and institutional investors. With DC plans being used as the foundation for retirement income it's become a direct risk for everyone.

I do think the govt could offer annuities. They could pool the money and the risk, and they don't need to make a profit. They could allow 401K, IRA rollovers etc, maybe some other contributions. But I don't think they should guarantee any specific return, just make payouts based on some reasonable projection. If people start living longer than their actuaries counted on, for example, lower the payments accordingly to keep it solvent. Don't try to get blood from a stone, adapt. -ERD50

That's been proposed by some economists as a way to avoid people making dumb investment choices and reduce risks of a market collapse destroying people's retirement savings. Of course it would never happen because of the investment industry lobby.