By J.R. Robinson
It is said that nothing tests the mettle of a long term investor like a good bear market. While the stock market’s slide over the past few weeks hardly qualifies as a bear market, it has already been enough to send scores of investors – both laymen and professionals – scattering for the hills. “Sell everything!” shrieked an analyst from one multinational bank.
Such hysteria and hyperbole can be particularly unsettling to retirees. Most have worked hard to accumulate their nest eggs and have been investing long enough to been through such trials and tribulations before. On the other hand, the gnawing notion that market conditions might lead to premature depletion is an understandable source of angst. So what is one to do?
As any financial advisor worth his or her salt will tell you, there are two primary risks to every retiree’s portfolio – sequence of returns risk (the risk of depletion caused by severe down markets early in retirement) and longevity risk (the risk of living so long that inflation adjusted withdrawals eventually outpace returns and lead to depletion). Longevity risk can be challenging from a planning perspective, particularly if late-life stage expenses are accelerated due to health care and custodial care expenses. Fortunately , however, there is one simple decision rule that may go a long way toward ameliorating sequence of returns risk – Don’t spend from the equity portion of your nest egg when the stock markets are down.
To demonstrate the power of this rule, let’s consider the three different withdrawal scenarios –
Investor A wants his portfolio to become more conservative as he gets older, so he spends down the stock portion of his portfolio first.
Investor B follows the standard financial planning wisdom of spending proportionally from each major asset class in his retirement accounts (stocks, bonds, and cash) and rebalances the portfolio each year to maintain a constant allocation.
Investor C does the same as investor B, but simply adds the simple decision rule or “guardrail strategy” that instructs him not to sell stocks or rebalance following negative return years.
To make these scenarios both realistic and “apples-apples,” we will assume the following basic conditions:
- A 30-year retirement life horizon
- A $1,000,000 initial nest egg
- A $45,000 initial withdrawal rate
- A 3% annual inflation adjustment
- An initial 60:40 Asset Allocation*
- .5% per year total investment management expenses
* In this model, we assume that the stock portion of the portfolio is comprised of 45% large cap, 30% mid- and small cap, and 25% foreign equities. To account for the current historic low yields on bonds, we assume a constant return on bonds of 2% per year, which is roughly in line with a 5 year CD or 10 year treasury. The 5,000 simulations generated for each scenario in this comparison were produced using a methodology called bootstrapping, which involves random sampling of monthly return data from benchmark equity indices from 1970-2014.
This table presents the percentage of simulations in which the investor nest eggs were depleted prior to the end of the 30 year horizon.
The complete results for each hypothetical investor simulation are presented as an appendix at the end of this article.
As we can see, the results of this analysis suggest that while an equity-first spending strategy might seem more conservative, it actually resulted in the highest risk of portfolio depletion prior to the end of the 30 year time horizon. Similarly, while the popular financial planning mantra of proportional withdrawals with annual rebalancing fared better than the equity-first approach, the results presented above support the notion that instituting our simple decision rule may reduce sequence of returns risk by an even greater margin.
Although these conclusions may seem counterintuitive to some readers, the findings are not new. In fact, there are a number of published, peer-reviewed research papers to support them. The concept of applying simple decision rules, including a guardrail strategy, to improve portfolio sustainability was introduced in an award winning March 2004 Journal of Financial Planning paper by Jonathan Guyton titled, “Decision Rules and Portfolio Management forRetirees, Is the ‘Safe’ Initial Withdrawal Rate Too Safe?” The efficiency of annual rebalancing was challenged in a 2007 Journal of Financial Planning paper entitled Is Rebalancing a Portfolio During Retirement Necessary? by SUNY Professors John Spitzer and Sandeep Singh.
More recently, prolific academic researcher Wade Pfau and widely followed Nerd’s Eye view blogger Michael Kitces continued this concept with their provocatively titled 2014 article, Reducing Retirement Risk with a Rising Equity Glidepath (Journal of Financial Planning). With respect to the latter, the authors suggest that depletion risk may be reduced still further by following a bonds first spending strategy. While there is empirical support for this position, this strategy is not likely to be embraced by financial planners or retirees, because the implication of this approach is that the retiree will have an increasingly heavy equity allocation later in life. As practical matter, it seems improbable that most investors in their 80s or 90s would feel comfortable with a nest egg that is nearly 100% equities – even if the there is a low statistical likelihood of their portfolios being depleted.
In summary, the theme of this article has been to provide data to help retirees feel more comfortable in refraining from selling equities during down markets. It should also be noted that an unstated implicit assumption is that new retirees should also be careful not to have too much allocated to equities, so that they may have enough stable assets in their portfolio to ride out prolonged bear markets and to enable them to avoid spending equities early in retirement.
The analysis presented in this article is purely hypothetical and should not be construed as direct investment management guidance. The simulations produced were based upon certain specified constraints and assumptions. To the extent that real world investor conditions may differ, so too may the results vary.
APPENDIX – COMPLETE SIMULATION RESULTS
The columns in these tables present the remaining portfolio balances in the simulation results in 5 year increments from the worst/bottom of the 5,000 simulation results to the 80th percentile result. In assessing the results, readers are encouraged to focus on the bottom half of the simulations (i.e., hope for the best, but plan for the worst).
Full simulation results for Investor A – stocks-first spending strategy.
Full Simulation results for Investor B – Proportional spending from each asset class with annual rebalancing.
Full Simulation results for Investor C – Proportional withdrawal from each asset class with annual rebalancing, except following years of negative stock returns.
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Mr. Robinson is the owner of Financial Planning Hawaii, and the co-founder and CEO of Nest Egg Guru, an innovative web-based application for stress testing retirement savings and spending strategies. Papers he has written or co-authored on retirement planning have appeared in numerous professional journals. Papers he co-authored on retirement income sustainability have won the CFP Board of Standards and International Foundation for Retirement Education Outstanding Paper awards.