We’ve talked about this before – on a few occasions – but it never hurts to revisit timeless truths that help keep things in perspective. Last year, a survey by Allianz Life Insurance Company of North America reported that more Americans would rather die than run out of money in retirement. While neither is a pleasant thought, at least the latter can be avoided.
Making your retirement savings last for thirty years is no small task. Assuming you have saved enough during your working years to be able to maintain your lifestyle, you have to have the know-how and gumption to manage this money in the distribution phase. And that’s when it counts. Make the wrong moves, and there’s a good chance you’ll run out of money before you run out of breath.
There are two culprits to sabotaging your retirement: the sequence of returns your portfolio experiences and reverse compounding. You can’t control the sequencing of returns; the market is going to give you what it gives you. You can, however, avoid reverse compounding – despite what the market does – if you understand this simple lesson: Selling assets for a loss so that you can spend cash will put you in the poorhouse.
In other words, if the market is down and you’re selling assets to sustain the same withdrawal rate, the negative sequence of returns coupled with the losses will create a huge reverse compounding problem. And here’s the kicker: the effects are far worse if you’re in the early stages of your retirement. Take a look:
Both portfolios start with $1,000,000 and have 5% of their first-year account value taken in withdrawals, adjusted by 3.5% for inflation each year thereafter. Both experience the same returns, with a final average of 6.5%, but the sequence in which they occur has been flipped. Portfolio X starts with early losses; Portfolio Y begins with early gains. The withdrawal rate is constant for each, no matter what their respective returns are, and for Portfolio X, this proves to be catastrophic. The portfolio has been spent by the age of 84.
Portfolio Y reaches age 100 with $1.2 million left. What’s the massive difference and how could Portfolio Y have managed a better outcome? Reverse compounding. We’ve all heard of positive compounding, but it can work the other way, too. Because Portfolio X experienced losses early on, the portfolio could never recover those losses. Add the constant withdrawal on top, and it’s easy to see how this person ran out of money.
This example shows you how your retirement can become a crapshoot if you’re not careful. The reverse compounding that occurs when assets are liquidated at a loss to raise cash, is what creates the sequencing of returns problem. Take away the need to sell and you remove the biggest flaw in current retirement income models. The good news is that you don’t have to rely on a stellar sequence of returns to ensure a successful retirement.
Bear markets are inevitable throughout your retirement, so how do you survive? A cash flow investment strategy will do a better job at protecting you from the sequencing of return problem than capital appreciation will. Living strictly off the income your portfolio generates, rather than selling assets to raise cash will eliminate the risk of reverse compounding.
This is a relatively new problem, seeing as the generations before us didn’t have to self-fund their entire post-working life, but your retirement doesn’t have to be left to chance. With this knowledge, the right investment strategy, and the fortitude to do the right thing – even when it’s hard and everything is incredibly uncertain – running out of money isn’t an option.