Adverse Return Sequencing

With markets fully priced (S&P cyclically adjusted P/E ratio at 26), returns over the next several years may be less predictable with a higher probability of negative front-loaded returns much like those that occurred in 2000-2002 and 2008 timeframes. A sequence of returns similar to those periods could cause extensive losses to retiree stock portfolios and play havoc on accumulated portfolio principal. Ultimately this could impair retirees’ ability to sustain their originally planned withdrawals and thus lifestyles. Bear in mind that a 25 percent loss to portfolio requires a 33 percent gain to fully recover.

Table 2 and the associated chart describe the actual damage done to an all stock portfolio as a result of annual withdrawals of $4.00 (or 4 percent of the original principal amount) during the 2000-2009 decade. The red column (left table) and red line (right graph) powerfully illustrate the potential damage attributable to adverse return sequencing. Note that the large negative returns coupled with persistently high withdrawals in the face of those declines causes the post-retirement portfolio to shrink by over half in only 10 years!                                                           

Possible Solutions

Advisors using established withdrawal rate assumptions now run the very real risk of allowing a potentially irreversible drawdown to occur that could permanently impair client portfolios. We believe impairment begins once a portfolio declines 20 percent greater than plan. A significant, multi-year bear market (similar to the 2000 time frame) could lead to widespread portfolio impairment causing serious consequences for those reliant on fixed incomes. After a decline of this magnitude portfolio recovery might be possible without extreme retiree withdrawal /lifestyle changes. The overall economy would suffer as lifestyles would be moderated and spending curtailed.

Fortunately, impairment may be managed, if not controlled through advisory support and intervention. Perhaps most important, more conservative advisory assumptions should be embraced.  Well established asset allocation recommendations (60 percent stocks and 40 percent bonds) may no longer be appropriate for retirees. The newly retired are especially vulnerable and should hold fewer stocks early-on to avoid the potential of portfolio impairment. Stock holdings of 35-40 percent in the first few years of retirement or until more desirable (lower) stock valuations avail themselves could reduce the risk of significant loss (see stress test data “B”). A larger allocation to non-traditional investments such as alternative assets may make sense.

Sustainable retiree withdrawal rates should also be analyzed as a way of avoiding portfolio impairment. The near universally accepted advisory industry rule of a 4 percent withdrawal rate in retirement, let alone the 4.5 percent “Safe Max” popularized by William Bengen, could prove too high over the next decade as heightened volatility and lower overall returns eat into retirees’ nest-eggs more rapidly. Note that a more conservative withdrawal of 4 percent of prior year-end principal would help minimize the drawdown of the portfolio by about 10 percent (to $59.53 vs. $48.31) over the decade in our all stock portfolio.  Clearly, basing withdrawals on the prior year-end principal amount can help to limit losses through difficult markets.