A look at how variable rates of return do (and do not) impact investors over time
What exactly is the “sequence of returns?”
The phrase simply describes the yearly variation in an investment portfolio’s rate of return. Across 20 or 30 years of saving and investing for the future, what kind of impact do these deviations from the average return have on a portfolio’s final value?
The answer: no impact at all.
Once an investor retires, however, these ups and downs can have a major effect on portfolio value – and retirement income.
During the accumulation phase, the sequence of returns is ultimately inconsequential. Yearly returns may vary greatly or minimally; in the end, the variance from the mean hardly matters. (Think of “the end” as the moment the investor retires: the time when the emphasis on accumulating assets gives way to the need to withdraw assets.)
An analysis from BlackRock bears this out. The asset manager compares three model investing scenarios: three investors start portfolios with lump sums of $1 million, and each of the three portfolios averages a 7 percent annual return across 25 years. In two of these scenarios, annual returns vary from -7 percent to +22 percent. In the third scenario, the return is simply 7 percent every year. In all three scenarios, each investor accumulates $5.4 million after 25 years – because the average annual return is 7 percent in each case.
Here is another way to look at it. The average annual return of your portfolio is dynamic; it changes, year-to-year. You have no idea what the average annual return of your portfolio will be when “it is all said and done,” just like a baseball player has no idea what his lifetime batting average will be four seasons into a 13-year playing career. As you save and invest, the sequence of annual portfolio returns influences your average yearly return, but the deviations from the mean will not impact the portfolio’s final value. It will be what it will be.
When you shift from asset accumulation to asset distribution, the story changes. You must try to protect your invested assets against sequence of returns risk.
This is the risk of your retirement coinciding with a bear market (or something close). Even if your portfolio performs well across the duration of your retirement, a bad year or two at the beginning could heighten concerns about outliving your money.
For a classic illustration of the damage done by sequence of returns risk, consider the awful 2007-09 bear market. Picture a couple at the start of 2008 with a $1 million portfolio, held 60 percent in equities and 40 percent in fixed-income investments. They arrange to retire at the end of the year. This will prove a costly decision.
The bond market (in shorthand, the S&P U.S. Aggregate Bond Index) gains 5.7 percent in 2008, but the stock market (in shorthand, the S&P 500) dives 37 percent. As a result, their $1 million portfolio declines to $800,800 in just one year. Its composition also changes: by Dec. 31, 2008, it is 53 percent fixed income, 47 percent equities.
Now comes the real pinch. The couple wants to go by the “4% rule” (that is, the old maxim of withdrawing 4 percent of portfolio assets during the first year of retirement). Abiding by that rule, they can only withdraw $32,032 for 2009, as compared to the $40,000 they might have withdrawn a year earlier. This is 20 percent less income than they expected – a serious blow.
Two other BlackRock model scenarios shed further light on sequence of returns risk, involving two hypothetical investors. Each investor retires with $1 million in portfolio assets at age 65, each makes annual withdrawals of $60,000, and each portfolio averages a 7 percent annual return over the next 25 years. In the first scenario, the annual portfolio returns for the first eight years of retirement are +22 percent, +15 percent, +12 percent, -4 percent, -7 percent, +22 percent, +15 percent, +12 percent. In the second, the returns from year 66 – 73 are -7 percent, -4 percent, +12 percent, +15 percent, +22 percent, -7 percent, -4 percent, +12 percent. (For simplicity’s sake, both investors see this 5-year cycle repeat through age 90: three big advances of either +12 percent, +15 percent, or +22 percent, then two yearly losses of either -4 percent or -7 percent.)
At the end of 25 years, the investor in the first scenario – the one characterized by big gains out of the gate – has $1.09 million at age 90, even with yearly $60,000 drawdowns gradually adjusted 3 percent for inflation. In that scenario, the portfolio losses are fortunately postponed – they come three years into retirement, and six of the first eight years of retirement see solid gains. In the second scenario, the investor sees four bad years out of eight from age 66-73 and starts out with single-digit portfolio losses at age 66 and 67.
After 25 years, this investor has … nothing.
At age 88, he or she runs out of money – or at least all the assets in this portfolio. That early poor performance appears to take a significant toll.
Can you strategize to try and avoid the fate of the second investor? If you sense a market downturn coming on the eve of your retirement, you might be wise to shift portfolio assets away from equities and into income-generating investments with little or no correlation to the weather on Wall Street. If executed well, such a shift might even provide you with greater retirement income than you anticipate.
If you are about to retire, do not dismiss this risk. If you are far from retirement, keep saving and investing knowing that the sequence of returns will have its greatest implications as you make your retirement transition.