By: Frank Armstrong, CFP, AIF
Place one hand on a hot stove, and the other on a slab of dry ice. Any statistician will tell you that on average, you are comfortable–but, of course, you know it’s not so. The markets’ average returns hide very long periods of both very weak and very strong performance. What’s more, averages are derived from past returns, but future returns are unlikely to exactly mirror the past. Naively relying on “average” numbers without considering the market’s wide variations can lead to disaster.
The models we use to describe market behavior become critical to our retirement planning. We often say that stock prices follow a random walk, in which each price change is independent of the one that preceded it. But studies have shown that there is more serial correlation than a random distribution would predict. In other words, both winners and losers repeat more often than they should. We also typically say that stock-market returns are normally distributed, but actually there are far more very good and very bad periods than there should be if market returns mapped out as a true bell-shaped curve; the “tails,” as they are called, are too fat.
For instance, based on the average daily market volatility of the preceding 50 years, the crash of 1987 should happen just once in 55 million years. (A statistician would say that the crash was a 16 sigma event, or outside of 16 standard deviations from the average.) So, investors can all go back to sleep, right? Well, not quite. It would be foolish to build a plan that didn’t take into account at least one more good crash during our lifetimes.
Getting more and bigger winners than you should is not catastrophic. But what if the losers are bigger and more often than we expect? How might that affect the plan? And if some of those big losses show up during the first few years of retirement, will you be able to recover?
Imagine that you retired in 1972. You had $500,000 invested in equities and planned to withdraw 8% ($40,000) each year for income. From 1973 to 1974, the market dropped 50%, and you made your withdrawals as expected. In just two short years, you were down more than 60%. Your remaining capital was about $200,000, so depleted that it could never recover under the weight of your planned annual $40,000 withdrawals–which, after the disaster, amounted to 20% of the remaining capital!
Investors must assess both the probabilities and the potential consequences of their strategies. For example, we know that if we play Russian roulette with the typical revolver, we have but a one in six chance of losing. Unfortunately, while the probability of losing is low, the consequences of a loss could ruin your whole day. The consequences of failure for a retiree, while not quite so absolute, are still unacceptable. Nothing can turn those golden years into a nightmare faster than being broke.
Given the possibility of market crashes, the wide variation of investment returns in the short term, and the consequences of failure, retirees must adopt strategies with the highest probability of success. They will want to build in a little extra pad for safety. The market neither knows nor cares whether you have retired. It can go down at any time, and stay there for several years.
This situation leads me to Armstrong’s Law of Averages: Don’t expect to ever see an average year. From this profound axiom, we can derive the corollary: Don’t expect retirement to be a long string of average years.
Conceptually, at least, it’s easy to structure an accumulation program. But the game changes at retirement. Both economically and psychologically, the stakes get higher. Time is no longer on your side. With no more salary coming in, there is no way to make up for investment mistakes. Risk takes on an entirely new meaning. The pucker factor is up.
The retiree looks at whatever he has accumulated and somewhat fearfully asks two questions: How much can I safely withdraw? How can I structure my account to maximize the probability that it will last forever?
In this instance, amortization refers to withdrawing a certain percentage of your nest egg each year in the expectation that it will reach zero after a predetermined number of years.
We often hear people say that the best plan is to die happy having just spent their last dollar. But amortization is out of the question. The time horizon of one’s retirement is long and not easily predicted. After all, if we plan to spend our last dollar at our average projected life expectancy, what happens if we screw up and live another five years? Remember that by definition half of all people will live longer than the average. In any event, over long periods of time, amortization doesn’t add much to income. Besides, drawing down your nest egg over a long period of time doesn’t really add much to your income. Even if we don’t care whether there is anything left over for the kids, there’s no alternative to keeping the principal intact.
As if the problem weren’t already tricky enough, we must expect at least modest amounts of inflation. So, our income requirement will grow throughout life. The longer our time horizon, the more inflation will eat into the buying power.
Retirees will soon discover that they are unlikely to meet any reasonable income needs using fixed-income investments alone. They must usually endure some equity risk to meet their objectives. The trick is to generate at least the required minimum return at the lowest possible risk level. Too little risk, and the portfolio may not generate enough return, while too much risk may “blow up” the portfolio during a string of bad years.
As objectives and risk tolerance are now quite different, the asset-allocation plan we put together during the accumulation phase must change. An appropriate plan must generate at least the minimum required total return at the lowest possible risk level. And it should have a good pad for safety. As a matter of policy, investors will want to complete the transition to a more conservative posture well in advance of their expected retirement dates.
The old schoolbook “low risk” income solution for retirees, widows, and orphans was to load up on money-market funds, municipal bonds, convertible bonds, utilities, real estate, preferred stocks, and other high-dividend-paying or interest-bearing securities. But this income-only approach generates an inefficient portfolio with far higher risk per unit of return than is necessary.
A far more efficient (lower risk) solution is to invest for total return rather than income. Risk can be more effectively controlled by varying the ratio of stocks to bonds in the portfolio than by purchasing the “low risk” income portfolio.
A variation of a “balanced” portfolio, including a diversified global-equity portion and a short-term bond portion, will generally come closest to meeting all the conflicting criteria. However, if available capital falls short of what is required, something will have to give. Either retirement must be delayed, or one’s lifestyle must be curtailed.
Coming Up: How much can I withdraw?
One big risk in retirement planning is directly related to one’s withdrawal rate. It is therefore under the direct control of the retiree. In the next installment, we will consider how much investors should reasonably expect to safely withdraw from their nest eggs.
Retirement Planning: Not Relying On The Averages
By: Frank Armstrong, CFP, AIF