You may be planning for your retirement.
And you might be thinking about what kind of risks you should be considering in your planning. The common fear is that in the first 5 years of your retirement, you experience a very large draw down of your portfolio.
On Investment Moats, I have highlight the risks of a negative sequence, and the havoc it could do to your retirement. Some friends have asked me: What if you have very good rate of return? Does that mitigate the risk?
Well…. Yes and No.
Because while sequence of return is a big monster to tackle, high inflation seemed to be a bigger monster.
I managed to do some data crunching recently. They told me that the most challenging 30 year period was either 1966, 1968 or 1969.
1969 was a real monster. But the most surprising thing about 1969 after I looked at the numbers was that…. I couldn’t detect what was so bad about this sequence.
I am going to show you how some indexes perform for the period of 1969 to 1998:
- We factor in a 1% annual expense ratio
- The portfolio is a 100% equity portfolio in that index
- The initial portfolio is $1000 and we will withdraw $40 in the initial year (the 4% withdrawal rate)
- After spending the $40, the year after, we adjust by the inflation for that particular period
We want to see if we are able to spend an inflation adjusted income for the 30 year duration.
A Pure S&P 500 Portfolio
First up, S&P 500 portfolio. The annual withdrawal rose by high inflation. In 10 years, the spending doubled to $80. In 24 years, the spending have doubled again to $160.
The money was exhausted by 1989.
The compounded average growth for this period is 11.07% a year. That is not… low.
What if the Retiree’s brother retire…. just 1 year later?
Now next, think of the brother of the retiree before, only for this brother, he chose to retire 1 year difference.
His net wealth last him for the full 30 years.
You realize that he went through almost the same high inflation. His compounded rate of return is 12.38%.
How can 1 year difference matter so much??
The whole of 1961 to 1970 was a tough decade. I realize for those years in that decade, you cannot have too big of a negative years in the first 2 years. In those high inflationary years, it is less forgiving.
I do not think anyone would term a -9% return as a very bad sequence. However, this -9% is the difference between a very successful retirement from a not so successful one.
So next, what if your rate of return is high enough?
The same time frame but… with Dimensional US Small Cap Value Index
We replaced the S&P 500 with a Dimensional US Small Cap Value index. Small cap and value factors did very well in the past. The compounded average growth is much higher at 14.99% a year (after fees).
Observe that in the same sequence, the small cap value is more volatile than the S&P 500. It dropped almost 30% versus the S&P 500, which dropped almost 10%.
In 1973 and 1974, it dropped a massive 31% and 18%. That is a 44% draw down.
In 1974, the $1000 portfolio dropped to $239.
However, this sequence was able to survive because the growth from this portfolio was crazy.
What about Fama/French US Large Value Research Index?
We have another example of an index that did well. This large cap value index had a smaller draw down but still larger than S&P 500.
This portfolio ended with 10 times as more money as originally started:
- after the high income requirement in this high inflation environment
- after poor negative sequence
1969 was a tough retirement year.
Here is how the three pure equity portfolio stack together. I had initially thought having a great investment return may not alleviate sequence of return risk.
However, if the rate of return is high enough, apparently even if the sequence is poor, inflation is higher, things will still work.
This might make a case of choosing an index that have a high expected returns. It lends weight to the factor tilts of Dimensional Funds available to Singaporeans via MoneyOwl, Providend and Endowus.
In the chart above we zoomed into the first 14 years.
I do wonder that, if you are in retirement, and you see your portfolio go down from $1000 to $239, will you keep to the plan and not make adjustment?
I think we will make adjustment because this leans very close to failure mode.
In retirement planning, we should view it less as a failure, but that the client will need to adjust his or her spending plan:
- Choose not to inflation adjust the income
- Step down the income by 20% since current withdrawal rate is too high
- Step up the income by 10% or slowly ratcheting up when you have more net wealth and can spend more.
In this way, you can be observe to be proactive and keeping up with the times.
Your plan for retirement is one:
- That you can stick with over a period of time
- And one that you are reviewing enough with someone who knows what they are doing, and adjusting when needed.
Some other take-away:
- 1969 was a bad year because 2 things add up
- High inflation increase your spending so much that it puts pressure on the portfolio
- Just a poorer sequence, although the sequence, by historical standards is actually rather livable for most
- It is hard to simulate this sequence in a Monte Carlo. How do you add up a specific scenario that is high inflation and poor sequence?
- Even if your money will last, there is every chance you will be forced to make stupid decisions
- If your rate of return is high enough, relative to inflation, relative to what you need to spend, it might work out
I will probably talk more about 1969 next time.
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