Jeffrey Ptak, managing director at Morningstar Research have a great data-infused article on how important are returns in the first 5 years of our retirement.
I don’t think this is quite surprising to me even before reading. Here is briefly what I know:
- Returns in income spending is important but not the most important attribute.
- The first 25-30% of your retirement period is the most important part. For example, if you need the income for 40 years, the first 12 years is roughly the most important. If you have a poor 12 years and failed to address them in your plan, you might… run out of money.
- Those challenging scenarios typically involve
- Early poor market returns (long or great magnitude of decline)
- Persistently high inflation (not one or two year inflation but a persistently high inflation period)
- Combination of the two above.
- Reducing the volatility drag in those early years, don’t overspend relative to your portfolio, allocate to assets that keep up with inflation, tends to be things to keep in mind.
Here’s Jeffrey’s article: How to Avoid Outliving Your Retirement Savings? It’s All in the Sequence
Jeffrey want to find out whether is there a year or point in your retirement where you can breath a sigh of relief you have rid the negative sequence of return monster.
They start with a current research on the safe withdrawal rate for a 100% equity portfolio:
This table shows the initial safe withdrawal rate for a 30-year income need period. The horizontal axis is different probability of how many simulations (that they did) where the portfolio survive 30 years. The vertical axis shows simulations on different equity and fixed income allocations.
I should remind you that Morningstar did not do the traditional Safe Withdrawal Rate way that Bill Bengen did in the 1990s. They use future expected returns, and their Safe withdrawal rate is at 90% probability of success and not at the extreme end. You can see the first row, which shows 100% equity allocation, if it is 100% success the initial safe withdrawal rate is 0.8%!
Why so low?
If you do math simulation and want high success, the number is going to be this low and you wonder how useful that is. This is why I would place more weight on historical simulations (like the traditional Safe Withdrawal Rate) than the mathematical one (that is not to say I don’t see their virtues).
So we see that the initial safe withdrawal rate (90% probability) is 3.1%, which means starting with $31,000 yearly on a $1 million portfolio.
90% means there are 10% of these simulations that will run out of money prematurely. The question is how important is returns?
Out of that 10%, 70% have lower values by the end of the first 5 years. The other 30% did not lose value, BUT they still fail.
This kind of show how important the first 5 years in returns is.
Jeffrey decided to invert and look at it the other way: What if we group the returns by 5 buckets from the best return to the worst return?
The worst return has about nearly 80% failure rates, or the portfolio value not lasting 30 years. But it is interesting that even with the best return, there are also probably 1 or 2 failure!
Difference Between Gaining Rather than Losing Money Through the First 5 Years of Income
There is a difference if you see gain rather than lost in value within the first five years.
The chart above shows the percentage of trails that will fail if there are more losses and more gain. Even a first year gain cuts the failure chance by half, relative to if it is a loss.
When Can we Breathe a Sigh of Relief?
If we deem failure to be having losses in the first five years of your income spending, how many more years do we have to wait until we avoid losses?
The data shows that at year 15, or half of the retirement, you can reduce the chance of loss to just 1%. that is pretty good.
Jeffrey concludes that it is less likely the losses outside of the first five years to cause the plan failure.
I guess for flexible spending system like the Guyton and Klinger withdrawal strategy, if you manage to avoid a negative sequence of return in the first 15 years, you can don’t adjust your spending after that.
Perhaps data kind of reach the same place.
What Can You Do to Tweak Your Plan so That Your Income can Last Longer?
The crux of this article is to highlight how critical the sequence of return risk is.
But it also kind of highlights another critical factor: Returns or market volatility in the later years matter less. Note I say less, not doesn’t matter but why is this critical? I will explain later.
And so there are a bunch of things that helps to alleviate negative sequence of return risks:
- Use a conservative income-to-portfolio value ratio or in other words a conservative safe withdrawal rate (SWR)
- Reduce the volatility of the portfolio through cash, fixed income, but have enough equities to ensure the portfolio can grow. The trick is always to find a balance. The cash, fixed income is to be spent if you encounter a poor first few years. This gives more time for the equity to recover.
- Have decision rules to not adjust for inflation when portfolio does not do well in the initial years. You will lose purchasing power, so there is a tradeoff but your portfolio is more healthy.
- Bond Tent
Here is what I do:
- For my most essential spending that I explain here, that is planned to fund with my income portfolio Daedalus, I use a low initial safe withdrawal rate of 2%. There are a few historical sequence that are volatile to the downsize such as Great Depression, 1973, 1968 and if we start our spending then with a conservative safe withdrawal rate, the income should stand a good chance to last a long time.
- For my basic spending explained here, I will start with 3% instead of 2%, but I will have a flexible spending decision tree with it.
- For most of my future medical sinking fund for health insurance premium and CI premium, I will fund it through a combination of CPF OA monies and CPF OA monies in a 80/20 portfolio with enough funding.
Don Ezra, who used to work at Russell Investments, an actuary and advise a few pension boards, craft 5 years of cash in his retirement portfolio with the rest equities. [How to get happy income]
I guess we can see how important is the first five years.
If most cash and fixed income is to address the first 5-10 years, then why do people still do things like “sell from equities into cash/fixed income to replenish the fixed income”?
I think:
- They don’t exactly know what is the big risk out there and therefore cannot be more targeted in how to address it.
- This feels psychologically more comforting.
There are failures even after first 5 years of good returns but I think we should also be aware that these are edge cases and if you wish to replenish fixed income or cash, that might not always solve the problem because the challenging sequence might be greater significant spending due to persistently high inflation.
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Kyith is the Owner and Sole Writer behind Investment Moats. Readers tune in to Investment Moats to learn and build stronger, firmer wealth foundations, how to have a Passive investment strategy, know more about investing in REITs and the nuts and bolts of Active Investing.
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Kyith worked as an IT operations engineer from 2004 to 2019. Currently, he works as a Senior Solutions Specialist in Insurance Start-up Havend. All opinions on Investment Moats are his own and does not represent the views of Providend.
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