This is the second part of a three-part series on retirement planning.

“Fragility is the quality of things that are vulnerable to volatility.”

— Nassim Nicholas Taleb

Life in retirement should be fun and stress free; the “golden years”. However, many people spend 20 to 30 years in retirement and funding these years may present a significant challenge. Here we will concentrate simply on the market risks of a distributing portfolio, or a portfolio of assets that will be used to fund retirement. Two of these risks I will briefly cover today: Volatility and Inflation.

Volatility and the Sequence of Returns

A lot of standard retirement planning, unfortunately, uses historic averages and Gaussian distributions to plan portfolios. Conventional retirement calculators often fail to correctly account for the risk of fluctuating returns. In his book “High Expectation & False Dreams”, Jim Otar does a great job of laying out the risk associated with what he calls the “Time Value of Fluctuations”. He suggests that many plans “show you the historic fluctuations of your selected asset mix during the last 20 or 30 years but they fail to incorporate the adverse effects of such volatility into your plan... if you do need to draw regular income from your investments it will deplete your portfolio a lot sooner than you think.” This process can be illustrated by simply showing the effect of what is called reverse-dollar-cost averaging (“RDCA”).

Let’s look at a simple example as illustrated in the following table. Consider a simple portfolio that starts at $5,000 and has an income requirement of $600 per period for four periods. The portfolio is invested in a stock whose initial price is $100. Initially 50 shares are purchased and the portfolio is up and running. Unfortunately the market took a turn for the worse and by period 1 the price of the stock had fallen to $70. In an accumulating portfolio this would mean that the investor could add more shares at a lower price. Unfortunately in a distributing portfolio, in order to fund the $600 income requirement the investor needs to sell 8.6 shares instead of the 6 shares he would need to sell had the price stayed at $100. In period two the price jumps back up to $80 and 7.5 shares are sold. In period three the price drops to $60 and 10 shares are sold and in the final period the price jumps back to $100 and 6 shares are sold. By the end of four periods the $5,000 turned into just $1,793. Had the investor just left this in cash and distributed the $600 for four periods he would have been left with $2,600. The total cost from RDCA is roughly 31 percent! (($1793/$2,600-1)*100 percent)

In an accumulating portfolio, dollar cost averaging can help you buy more assets at cheaper prices over time. In a distributing portfolio, however, fluctuations can actually become a detriment to the longevity of your assets and future funding. Otar (2006) suggests that this can “reduce the portfolio life by as much as 50 percent” based on market history.

Monte Carlo simulation is a very common tool used in retirement forecasting. Unfortunately its basic premise is that it assumes all outcomes are random and does not take into account secular trends that have developed historically. These sequences of periods are not purely random or evenly distributed and can have a large effect on the outcome of your portfolio. Aftcasting, or forecasting potential outcomes by using various historic periods, helps us account for various sequences of returns. Let’s take three examples to show how this can work. In the first we will graph what happens if you retired in 1929. In the second, if you retired in 1962. The final if you retired in 1982. For each scenario we assume a 65-year-old uses a conservative portfolio (40 percent equities, 45 percent bonds and 15 percent cash) of $1 million with a withdrawal of $60,000 per year, indexed to actual inflation. The graph below plots the portfolio values over time and adds a line that shows a “traditional model” that assumes averages over the period.

Stock returns use the S&P 500 from 1927 to 2012, adjusting dividends for 30 percent withholding. Bond returns for 1927 to 1971 is the US ten-year treasury returns, from 1972 to present returns reflects the BofA Merrill Lynch US Corporate & Government Index. Cash returns from 1927 to 1976 are T-Bill returns from the FRED database, from 1977 to present they are from the BofA Merrill Lynch US 3-Month Treasury Bill Index.

If you were unlucky and began your retirement in 1929 or 1962, your portfolio would deplete in less than 25 years or before your 90th birthday. If you were fortunate and retired at the beginning of 1982, your retirement would be easily funded and your estate would have grown substantially!

So let me tell you a little secret. In the real world, it does not matter how accurate your assumptions are on average for your forecasts into retirement. What really matters is the SEQUENCE OF RETURNS that you experience during the early years of your retirement — especially the first four years or so. The life of your portfolio actually depends to a very large degree on how lucky you are in regards to the secular trend you retire in and inflation of that period. Otar suggests, a well-designed retirement plan should ensure 90 percent of the time the portfolio will not deplete before your expected end date.

Inflation

Inflation impacts withdrawal rates and asset prices. If the actual rate of inflation varies considerably from “average” rates many assume, your portfolio is at great risk of being depleted rapidly as you need to withdraw greater and greater amounts just to maintain your standard of living. High inflation also has a negative effect on financial assets. In the example above where the person retires in 1962, we can see how inflation can dramatically reduce the longevity of one’s portfolio. Even though the market over this period was virtually flat from beginning to end, the large swings in value caused by escalating inflation damaged returns and lead to an escalating cost from withdrawals. In fact it even depleted three years faster than the portfolio that was held through the Great Depression!

Protecting the Nest Egg

How do you remove as much luck from the equation as possible? What can you do to help ensure a fully funded retirement with a lower risk of running out of funds due to inflation? There are a few simple things to consider that will greatly enhance the chances you do not run out of money:

1 Keep withdrawal rates low: Keeping your withdrawal rate low greatly increases the lifespan of your assets and the chance it will fund your retirement for years. A sustainable withdrawal rate typically runs around four percent of the value of the portfolio. This of course needs to be constantly monitored with consideration of the performance of the portfolio over time. Withdrawal rates of around four percent for 50 percent equity and 50 percent fixed-income portfolios typically offer minimum portfolio lives of 30 years. Once withdrawals rates exceed ten percent, portfolios can deplete rapidly and decisively, usually within four to ten years (Canadian Securities Institute). In general, the lower the withdrawal rate the less of an impact luck has on the longevity of the portfolio.

2 Optimise the asset mix and rebalancing: Taking more risk does NOT necessarily mean having a greater chance of extending the life of a portfolio (more on that next week). Different asset mixes are optimal for varying withdrawal rates. Also, frequent rebalancing can have a very negative effect on distributing portfolios. If the withdrawal rate is five percent or less, it is actually better to rebalance once every four years at the end of the US Presidential election year (IBID).

3 Hedge inflation: Unfortunately, in the short run, nothing really offers a great hedge against inflation. In the longer run, however, stocks and treasury inflation protected securities “(TIPS”) do provide good hedges on inflation. Ensure these assets are part of your plan to prevent the devastating effects of escalating inflation. The trick is trying to match inflation in Bermuda which can often times be much different from that in the US or the rest of the world. Real estate does offer somewhat of an inflation hedge as well. It could be PART of a retirement plan, just not THE retirement plan.

This is a cursory look at some major retirement market risks. Distributing portfolios are much different than accumulating portfolios and they need to be managed in a different way. Conservatism, risk control and scenario analysis is crucial to ensure success. Fluctuations in market returns and inflation are two factors that matter a lot. Next week we will look at a few retirement myths.

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Anchor Investment Management Ltd. to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision.

Sources: Time Value of Fluctuations” by Jim Otar, 2006, pg. 6; “Advanced Retirement Management Strategies”, Canadian Securities Institute, pg. 9.47; IBID, pg. 9.49