A few weeks ago, I wrote the first in a series of blogs dedicated to the distribution problem that advisors and retirees are facing today. Part 1 focused on the clarifying the unique challenge that comes with the distribution stage of investing. Indeed, as investors begin to start liquidating their accumulated assets as a replacement paycheck after they stop working, the math changes. Inflation and sequence of returns are two key risks associated with this investor stage. Today, I am going to zero in on sequence of returns risk and shed some light on how many advisors are inadvertently setting inappropriate expectations for their clients in retirement.
Just in case anyone is wondering how the math changes in the distribution stage, allow me to illustrate. The first chart that you see shows the growth of $100,000 based on historical returns of the S&P 500 Index (total return) since the beginning of 2000 in blue. The orange line represents that same $100,000 growing over the last 18 years – except the order of returns have been reversed. So, although the accumulation path is drastically different, both scenario’s end up with the same exact value today. In other words, the order of returns does not matter.
Now, take that same scenario but pull out withdrawals of 5% per year (with a 3% cost of living adjustment). The original order of returns (2000 thru Q2 2018) runs out of money 15 years into the hypothetical. The reverse order of returns (Q2 2018 – 2000) has a positive balance of $124000 at the end. The order of returns clearly matters in the distribution stage. That’s what we mean by sequence of returns risk.
The primary way that many advisors attempt to mitigate this risk for their clients in the distribution stage is to take some risk off the table and diversify the portfolio. Here’s what a 60/40 mix of the S&P 500 and the US Aggregate Bond Index would look like in the same distribution scenario:
Clearly, the diversification benefits the client in this scenario. Instead of running out of money 15 years into retirement, the client has a little over $37,000 left after the full 18 years. The assets won’t last much longer, but at least this is an improvement. The problem I have with an advisor presenting this as a solution to a client for their income needs is that it’s all based on historical returns. Yes, I get it – no one knows how stocks will perform over the next 10-20 years, so the next best thing is to use a long historical time period as a reference point. I don’t have any better idea than the next person as to the performance of stocks going forward. We could continue to see significant corporate earnings growth and valuation expansion that underpin high returns over the next 10 years, or we could see a significant downturn due to any number of reasons.
The 40% allocated to fixed income is a different story. We do have a better understanding of bond returns going forward relative to the past 15-20 years. Either rates will continue to stay low and bonds will earn the yield they are paying. On the flip-side, if rates increase that will increase the yield return, but will be partially offset by the decrease in the price of bonds that investors are currently holding. In either scenario, it’s hard to imagine that the US Aggregrate Bond Index will average the 5% annualized return over the next 18 years that it has since 2000. A more appropriate rate of return for the 40% fixed income allocation might be 3% going forward. If we adjust to those expectations for “future” sequence of returns risk, here’s what that impact on the portfolio looks like:
As you can see, lower interest rates going forward will make it more difficult for portfolios to last through retirement compared to previous generations. Here’s a quick read from FS Investments that I came across outlining the difficulty of the traditional 60/40 portfolio going forward.
History is a useful guide to the future when examining potential market cycles. However, when it comes to conservative asset classes, advisors and investors should be careful to not expect the next 20 years to look like the previous 20 years. Next time, in the final installment of this series, I will discuss some of the prevailing distribution strategies and present a viable alternative that income oriented investors should consider.