Retirement: Sequence Of Return Risk, A Deeper Look

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Co-produced with Trapping Value and PendragonY

We recently touched upon how Sequence of returns can create a risk for retirees and soon to retire investors. Briefly, this is a risk that is thought to be outside the control of investors and can create rather disastrous consequences for retirees. The sequence of returns risk refers to the risk that investors face should they have a tough bear market right around when they retire. We agree that this is a big risk but we want to explore ways to reduce this.

Today, we are going to take a deeper dive to illustrate our point further. We will be working through some numbers step by step to show how this risk impacts the investor. We will then focus on one mitigating strategy.

Which one would you rather be?

As investors we reflexively embrace the “more returns is better” hypothesis. After all, what could be wrong with having more? “Greed is good” as the Wall Street adage goes, so more returns does satisfy that. So for example, given a choice, which of these two investors would you rather be going into retirement?

Source: Author’s calculations

The choice does seem crystal clear. Investor B is doing exceptionally better by year 12 and is way ahead in the game. But we did cheat a bit when we showed that. Remember, we mentioned that these two investors were going into retirement. It would be extremely unusual for these two investors to then not take out any cash during retirement. Let’s see what happens to the “lesser” of our retirees during his retirement.

Investor A is relying on 7% returns to be funded from his nest egg and withdraws $70,000 a year.

Source: Author’s calculations

12 years out, things are looking ok, but the last 3 years have sapped some joy out of what was a great start. Still after 3 years of a bear market, Investor A thinks he has seen the worst of it and is optimistic that stronger than 7% returns will power his remaining retirement years.

What about Investor B? Remember he is the one who in our example has experienced better returns than Investor A. How does he do? He too was counting on 7% returns and withdrew $70,000 a year. He has however fared far worse unfortunately, despite being lucky enough to get better overall returns in the market.

Source: Author’s calculations

Investor B starts off with a bear market. The earlier horrendous portfolio returns have decimated his nest egg and at this point funding $70,000 a year is impossible. Even after 9 consecutive years of positive returns (years 4-12), Investor B would require an astounding 39.26% annual returns to keep withdrawing $70,000 a year. Just based on the timeline though, the law of averages would say the opposite. That investor B is due for a bear market. The nest egg looks doomed even though Investor B “enjoyed” a better set of overall market returns.

Key difference

The most important difference here is that the early bad returns forced investor B to liquidate at rather awful prices. Investor B was breaking the adage of Buy High and Sell Low to the maximum levels. Granted a retiree is forced to sell at all prices but by selling huge percentage amounts at an earlier time point, Investor B’s portfolio hit the skids and could never recover.

Is there anything that investor B could do differently?

In our previous article we mentioned mitigation strategies and we are going to work through the calculations here to show how they could be applied on a portfolio level. In our example above we have assumed that both A and B invested in the general indices and as we know they throw off very little income or yield. But what if, instead of going for the growth of the general stock market, investor B had invested half his portfolio in quality high-yield picks designed to generate big income but provide relatively low price appreciation. We are going to run through some numbers here to see how things would be different. But first let’s make sure we understand the underlying assumptions.

1) Investor B divides up his $1,000,000 equally into the index ($500,000) and a quality set of high-dividend picks yielding 9.4% ($500,000). 9.4% is very close to the average of our high dividend picks (9.7%).

2) During the recession, some of the dividends on his portfolio are cut and his high-yield portfolio now yields 7% on original cost. This is a vicious hit and one that is extremely unlikely but one we feel helps us look at a real worst case scenario.

3) At the end of 12 years his $500,000 portfolio has no growth and is back to $500,000 in value. Remember that during investor B’s 12 years in the market the index moves up by 87%, so assuming a flat value at the end of 12 years for high dividend stocks is not overly optimistic.

4) He also experiences zero growth in dividends from this side after the cut during the recession. This again is a very pessimistic scenario.

Source: Author’s calculations

The value of the income oriented portfolio in between those two dates is not that relevant for our modeling and we are leaving it out. We are most interested in the income stream and we have taken into account a big hit (25% permanent reduction) to that stream. We used big cuts as we wanted to make sure we were modeling a pessimistic scenario rather than one where there were just blue skies.

Now, to fund B’s income the 9.4% yield from high dividend picks provides a very huge buffer. In fact in the first year he has to tap only $23,000 ($70,000 minus dividends of $47,000) from his index portfolio. The amount of selling from the index funds does increase as dividends are cut on high yield picks. In the second year investor B taps $31,500 ($70,000 minus $38,500) and this increases to $35,000 ($70,000 minus $35,000). Does this fare better than the earlier case where B just had $178,257 left? Yes it does, by a landslide.

Source: Author’s calculations

This method leaves the investor with $627,677 handily outpacing the $178,257 in our original scenario. While Investor B still has a rocky road ahead, thanks to relying on high income picks, he has a much better shot of dealing with what lies ahead.

Did we cheat?

Numbers can be complicated for investors and it is not too difficult for scenarios to make apples to oranges comparison. In our case above, we think we have been fairly rational in making assumptions but investors are bound to ask, did we make things better by inflating our overall returns? Did we bump up the returns on our high yield portfolio? We actually did not do that.

Remember our Investor B had the index appreciate by 87.11% during his retirement.

Source: Author’s calculations

Our HDO portfolio was modeled to produce the almost exact same return, but only that it came from income and not capital appreciation.

Source: Author’s calculations

So even if we just match the market returns, we can create a tremendous improvement over sequence of returns risk, by biasing our portfolio towards more income.

How have we done?

A $50,000 portfolio invested in our portfolio on January 1, 2016 is now valued at $83,978 (with dividends re-invested). It has returned an average of 16% per year! We have done this while focusing on investments that dole out huge amounts of income. We focus on value and it has been a difficult time in general for value investments. We can see below that value investments have significantly lagged the index during the time the service has been investing in the market.

Data by YCharts

This has made things harder from a total return standpoint, but the flip side of that is there are still plenty of opportunities in this market from a value perspective. Keep in mind that with interest rates declining across the globe, high dividend stocks and bonds are set to outperform the rest! Dividend investing is a defensive investment style that generates regular cash flows for investors and tends to outperform when markets are volatile. We continue to use our large and talented investment team to find the best opportunities for you.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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