Topical Issues

Managing Sequence of Returns Risk.

We all know that asset markets have their ups and downs.

The assumption that most investors make is that these will even out in time – that the well-observed tendency for markets to rise over the long term will compensate for short-term declines along the way.
But this assumption can be cruelly misplaced – especially when a bear market coincides with the start of retirement.

The crucial concept here is ‘sequence-of-return risk’.

In essence, the order in which an investment portfolio encounters rises and falls in the market can have a dramatic effect on outcomes – so that the end-value of one portfolio may be very different from another even if the sequence of returns they have experienced has been only slightly different.

This is because the compounding principle works against investors who are making withdrawals during bear markets.
When you invest into rising markets, you harness the power of compound interest; your capital earns interest, and then the next year it earns interest on both its initial value and the interest reinvested.

But if you start making withdrawals from your pension fund at a time when markets are falling, you become a victim, rather than a beneficiary, of compounding.

It is not just the withdrawal that is gone, but so too are the future returns that that money might have generated had it been left invested.

The Difference a year can make.

We can illustrate this with two hypothetical investors.

We use US data, not least because the US market affords the long-run, real-world information needed to show the full effects of SORR over time, but the maths does not lie and it applies everywhere.

The first investor retired in January 1973, at the start of the seventh-most severe bear market in US history. The second retired a year later, in 1974, the year in which the bear market reached its bottom and began to recover. Both expected retirement to last for 35 years.

Let’s assume that both entered retirement with $500,000 invested in a portfolio equally split between US equities and US bonds, an assumption that again allows us to assemble real-world data as international investment was uncommon at that time.

We should also assume that the portfolio was rebalanced each month and that both investors planned to withdraw $25,000 each year, adjusted for inflation.

The retirements of the two investors overlap for 34 of their 35 years.

If neither investor had made withdrawals over the course of their retirement periods, the returns they made would have been broadly similar: a 5.23 per cent real return per year for the 1973 retiree and a 5.10 per cent real return for the 1974 retiree.

On the face of it, then, the 1973 investor entered the market at a marginally more advantageous time, allowing for a slightly higher average annual return.

The 1973 retiree would have run out of money 23 years into retirement.

By contrast, the 1974 retiree would have maintained a balance of $300,000 for most of the 35 years of retirement and would end that period with around a quarter of the initial amount to leave as a bequest.

The difference in these outcomes offers a striking illustration of SORR. A single year’s difference in the start of the retirement period led to a drastic disparity in the performance of the portfolios.

This is simply because the 1973 retiree bore the full brunt of the bear market as he or she began to make withdrawals – and that bear market continued until hitting its bottom in October 1974.

The 1974 investor experienced only nine or ten months of the bear market, which meant the initial withdrawals into a falling market had a less severe impact on the size of the portfolio over the longer term.

A potential solution: dynamic spending

As our examples show, SORR can have a devastating effect on the performance of a retirement portfolio.
Obviously, there is nothing that individual investors can do to change the behaviour of the world’s financial markets.
Nor can they combat the power of compound returns. But investors can act to mitigate the effects of bear-market conditions by adopting a different, more flexible spending strategy.

The key to this is simply to reduce portfolio withdrawals when markets are falling. We call this ‘dynamic spending’.

Under a dynamic-spending approach, you adjust your withdrawals according to market performance. So, after a poor year for markets, you withdraw less than you had originally planned – although the income need only be reduced by a surprisingly modest amount.

This may cause you some short-term privation through reduced income, but it does help to mitigate the compounding effect of taking significant withdrawals from a portfolio that is already being diminished by negative returns.
Conversely, when markets recover, the dynamic-spending approach allows withdrawals to be ratcheted higher.
Floors and ceilings
The dynamic-spending process acknowledges the way in which compounding works against an investor who is making withdrawals at a time when markets are falling.

By withdrawing less during those periods, you shield the portfolio from the full effect of the damage done by the combination of withdrawals, market falls and compounding.