A new type of mutual fund was introduced in late 2007, by the fund industry, called managed-payout funds. The goal of these funds is to give retirees a steady stream of income. At the time, they were touted as being an easy way for investors to get regular income payouts, professional money management and relatively low fees. Early players in the managed-payout fund arena were Fidelity, Vanguard, John Hancock, and Charles Schwab.
These funds demonstrate something known as the “sequencing of return problem” for retirees. If a retiree experiences losses early in their retirement, principal is quickly depleted and the amount of time until the retirement portfolio runs out of money is reduced.
Like the new retiree, these funds were decimated by the stock market plunge of 2008 – 2009. Just a few years after their inception, many of these funds were unable to meet their obligations to retirees and were basically returning principal.
“The plight of managed payout funds dramatizes boldly, what can happen to investors if they experience a serious market downturn early on, when they are starting to draw down their payments in retirement,” said Dan Culloton, a fund analyst at Morningstar.1
The Sequencing of Return Problem
When you are in growth mode, sequence of returns doesn’t matter. Regardless of whether a portfolio experiences weak or strong returns early on, the ending market value will be the same.
Let’s look at an example:
Assume we have two portfolios, X and Y. Each starts with $500,000. Neither is taking withdrawals. Portfolio X experiences early losses. Portfolio Y experiences early gains. As you can see from the chart below, there is no difference in the ending value.
This is not the case once you begin taking distributions. As you can see from the chart below, Portfolio X experiences losses early on and runs out of money in less than 20 years. Portfolio Y has strong early returns and is still going strong at age 100.
Even though both averaged 6.5% return, the difference in the two outcomes is massive!
This demonstrates a tragic flaw in a traditional capital appreciation portfolio when your investment objective is income replacement. There is just too much dependence on luck. You are basically betting on a random sequence of numbers over 30 years and the consequences, if your bet doesn’t pay off, can be catastrophic.
How cash flow solves the sequencing of return problem
Capital appreciation is when you buy something in hopes it will go up in price. When it does, you sell it for more than you paid for it, and the profit is called capital appreciation.
Cash flow is money that comes to you while you still own the asset. Examples of cash flow would be rent, royalties, interest, dividends, and option premiums. The key characteristic of cash flow is that you do not have to sell the asset in order to make money.
Another important characteristic of cash flow investments is cash flow is typically tied to the amount invested rather than the market value. Take a bond, for example. The yield is a percentage of the face value. A $1000 bond paying 6% will pay $60 in cash flow whether the bond is worth $900 or $1100.
Imagine your monthly expenses are $9000 a month and your portfolio generates $12,000 a month in cash flow. So long as the $12,000 is not connected to the market value of the portfolio, the sequencing of return problem goes away. Your portfolio withdrawals would be unaffected by the sequence of return because there is no need to sell assets when the market is down.
That 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. Cash flow is the blindingly obvious solution to the sequencing of returns problem, among others.
(If you would like to learn more about cash flow versus capital appreciation, and the other problems cash flow may be able to solve, as part of a retirement portfolio, I would recommend the free special report at Snider Advisors.com, titled “How to Not Just Survive, but Thrive, in Turbulent Financial Markets.”)
Square pegs in round holes
When planning for retirement, be aware that you are seeking solutions to a relatively new problem. It is only in the last ten to fifteen years that academics have seriously begun working on the problems created by our need to self-fund what is likely to be thirty years in retirement.
In 1935, when Social Security was first created, the life expectancy at birth of American men was about 58 years. Today, the life expectancy in the United States, according to the CIA World Book, is 78.24 years and continues to climb. It has only been since the late 1980s that IRAs and 401(k)s became commonplace. And as late as 2002, when I first started lecturing on the topic, most people had never heard of the 4% maximum sustainable rate of withdrawal.
The financial services industry has a tendency to try to shove square pegs in round holes. The incentives of the compensation system pervasive in the industry just don’t reward fresh thinking. Old ways die hard, especially when they are lucrative.
You live in a Desperate Housewives world. Leave It To Beaver solutions to retirement planning are far too dependent on luck. To solve today’s most pressing retirement issues, you are going to have to think and act different than your parents and grandparents did. And that is likely going to mean thinking for yourself.
1. Funds Featuring Managed Payouts Off To Rocky Start. (2009, February 11). InvestmentNews. Retrieved from http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20090201/REG/302019983/1030/MUTUALFUNDS.
No statement in this article should be construed as a recommendation to buy or sell a security or to provide investment advice unless specifically stated as such. All investments involve risk including possible loss of principal.