Investors with long time(?) horizons can tolerate the risk of having negative returns in some years and positive returns in others as they pursue greater long-term returns. As one’s one horizon shrinks, though, the sequence of returns becomes much more important. The impact of market down drafts and volatility when you’re near, or beginning, withdrawals will be much more pronounced.
With regard to the risk associated with the sequence of returns, some general principles apply.
- It is better to earn higher returns earlier in the period when an investor begins taking withdrawals.
- Earning low or negative returns in the early years of a withdrawal period or shortly before a withdrawal period begins will significantly hinder the long-term growth of an investor’s principal.
Even for investors who have amassed significant savings, a sudden and severe market downturn at the onset of major life events like college or retirement can impair their ability to pay for them. For this reason, we believe it can be prudent for investors to work with their advisors to reduce the downside potential in a portfolio when they are approaching a period of expected withdrawals.
An Example of the Importance of the Sequence of Returns
Consider a hypothetical investor who retired on January 1, 2008, the year of the Global Financial Crisis. The major drawdown in the market that occurred during that year, at the outset of this investor’s withdrawal period, would have had a lasting impact on their principal.
To illustrate this point, we’ll compare the value of the investor’s principal over the next five years, with another investor who experienced the severe loss at the end of the five years, rather than at the beginning. For simplicity’s sake, we’ll assume both retirees had a nest egg of $1 million dollars and needed to withdraw $60,000 at the start of each year to cover their annual income needs. We’ll also assume they have their principal invested entirely in U.S. large-cap stocks. We’ll use the returns of the S&P 500 Stock Index for January 1, 2008 through December 31, 2012 for the first investor, and then reverse the order of the annual returns over those five years for the second hypothetical investor. (This hypothetical scenario is for illustrative purposes only.)
Investor 1: Major Market Downturn at Start of Withdrawal Period
1/1/08 – 12/31/12. This hypothetical example is for illustrative purposes only.
|Starting Value of Principal after $60,000 Annual Income Withdrawal||Annual Return of S&P 500||Year-end Value of Principal|
|Year 1 (2008)||$940,000||-36.55%||$596,430|
|Year 2 (2009)||$536,430||25.94%||$675,580|
|Year 3 (2010)||$615,580||14.82%||$706,809|
|Year 4 (2011)||$646,809||2.10%||$660,392|
|Year 5 (2012)||$600,392||15.89%||$695,794|
Investor 2: Major Market Downturn Later in Withdrawal Period
Portfolio results using the annual returns of the S&P 500 from January 1, 2008 to December 31, 2012 in reverse order. This hypothetical example is for illustrative purposes only.
|Starting Value of Principal after $60,000 Annual Income Withdrawal||Assumed Annual Return||Year-end Value of Principal|
The S&P 500® Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. The index includes reinvestment of dividends but does not include fees, expenses, or taxes. The index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any fund. Past performance does not guarantee future results.
As you can see from these examples, the investor who experiences the significant loss early in their withdrawal period ends up with less money. Even though the annual returns are the same, their order matters. In this example, for the investor with $1 million entering retirement and a need for $60,000 in annual income, the early loss equated to $127,431 in less principal at the end of five years.
Investors Need to Examine Returns Differently
Given the impact of sequence-of-returns risk, investors who are already withdrawing, or about to start withdrawals, need to be mindful of certain facts.
Looking at average annual returns is not enough. In the above examples, the average annual return for both investors is the same. Both would have earned an average annual return of 4.44% over five years.
Taking withdrawals is what changes the math and makes the sequence of returns important. In the above examples, if both investors had left their $1,000,000 alone and not made any withdrawals, after five years they would have had the same amount -- $1,085,637 -- in both return sequences. But when you are making withdrawals, the order of your returns clearly matters.
Evaluating Investments When You’re Close To, or Already Taking, Withdrawals
To evaluate investments when someone is near or in the early phases of a withdrawal period, people need to look beyond average annual returns. People need to evaluate performance with measures that take into account risk.
The Sharpe ratio is one measure that people use to examine an investment’s risk-adjusted returns. The Sharpe ratio looks at the returns an investment generates, relative to the risk that it assumes. Risk is gauged by the volatility of the returns.
Volatility – which is typically measured as the standard deviation of returns – can come on the upside and the downside. Investors typically aren’t concerned about the volatility on the upside. It is volatility on the downside that is worrisome, and as illustrated above, downside volatility early in a withdrawal period will have a lasting negative impact on an investor’s principal.
The Sortino ratio is a more precise measure of the true risk of volatility because it only looks at the impact of down market volatility on returns. A high Sortino ratio for an investment would suggest a fund can deliver strong returns over time even through periods that include declining markets.
Maximum drawdown is another measure to consider. It looks at the maximum loss an investment incurs through a market cycle by comparing its value at its peak with its value at its trough. Less volatile investments will experience much lower drawdowns during periods of volatility.
When taking withdrawals, investors will want to consider investments that have historically high Sortino ratios and low maximum drawdowns.
Minimizing Sequence Risk in an Overall Portfolio
Finding investments that have less volatility during down markets does have some costs. Generally, these investments won’t realize 100% of the gains that other, more volatile, investments do during up markets. But that is why advisors often ask their clients, “Would you be willing to sacrifice some of your returns on the upside for more protection on the downside?”
For investors who are taking withdrawals from their accounts, given the sequence-of-returns risk, the answer to this question is likely to be an emphatic, “Yes!”
For certain long-term financial needs, investors still need significant growth. Given today’s long lifespans, retirees could be drawing on their investment accounts for 20 to 30 years. To keep ahead of the impact that even a modest annual return rate of inflation could have over decades on the purchasing power of their savings, investors need the opportunity to realize significant growth. So they will want to pursue the equity market’s considerable upside potential.
In addition to inflation risk, though, investors need to be mindful of sequence of returns risk. Dedicating at least a portion of their portfolios to investments that have less downside risk could lessen the negative impact of a major market downturn in the early years of their withdrawal period.