Sequence of Returns: The Silent Retirement Risk

Posted Apr 7, 2010 | Jason D. Landers

Retirement for Americans has a different look to it these days. For those of us not working in the public sector, the odds of having a defined benefit plan, or pension, are getting less and less every year. In the Pension Insurance Data Book of 2008, single employer pension plans that were insured by the Pension Benefit Guarantee Corporation went from 98,500 in 1980 to about 27,900 in 2008. If these trends continue retirees are going to have to create their own nest eggs to ensure that they have the retirement lifestyle they desire. Unfortunately, Social Security benefits do not cover most Americans retirement dreams, they merely bridge a gap. Without a pension the remaining sources for retirement income to supplement Social Security will fall into the hands of 401k plans, IRAs, and personal savings accounts.

This leads me to this paper’s main focus: sequence of portfolio returns. Whenever one has to rely primarily on retirement savings and other investments to provide the majority of a family’s retirement income, the conditions that are present when withdrawing those assets play a very important role. A great way to illustrate this is to compare two different scenarios. In the first scenario, Client A is in the accumulation, or working years. You’ll see by the table below that in this scenario we will be comparing an average rate of return with good years coming first in Portfolio 1, and bad years coming first in Portfolio 2. (The returns for each portfolio are inverse).

	Portfolio 1		Portfolio 2
Age	Return	Acc. Value	Return	Acc. Value
51		$200,000		$200,000
52	(-23.1%)	$153,790	22.7%	$245,400
53	(-6.1%)	$144,369	19.6%	$293,584
54	(-0.3%)	$143,981	18.0%	$346,546
55	24.5%	$179,211	24.5%	$431,340
56	18.0%	$211,541	(-0.3%)	$430,182
57	19.6%	$253,077	(-6.1%)	$403,831
58	2.7%	$310,525	(-23.1%)	$310,525
59	(-23.1%)	$238,777	22.7%	$381,014
60	(-6.1%)	$224,151	19.6%	$455,826
61	(-0.3%)	$223,549	18.0%	$538,056
62	24.5%	$278,248	24.5%	$669,709
63	18.0%	$328,443	(-0.3%)	$667,911
64	19.6%	$392,933	(-6.1%)	$626,998
65	22.7%	$482,128	(-23.1%)	$482,128
	6.5%	$482,128	6.5%	$482,128

Source: Manulife Investments

Notice that in Portfolio 1 we had the poor returns come at the beginning of the 15 year period and in Portfolio 2 the poor returns came toward the end of the 15 year period. The end result however is that we had the same average rate of return and the same ending account value for both portfolios. This means that at the end of the period, Client A would have the same account value with either of these scenarios.

Now, let’s see what happens when Client B, who recently retired from XYZ company, needs to pull 5% from portfolio assets to supplement Social Security income. This income need is indexed for inflation each year by 3%. The following table again shows the same test with Portfolio 1 having bad returns early and Portfolio 2 having bad returns late. The difference in this scenario is that we are pulling annual income from the portfolio:

	Portfolio 1			Portfolio 2
Age	Return	Withdrawal	Value	Return	Withdrawal	Value
65			$500,000		$500,000
66	(-23.1%)	$25,000	$365,250	22.7%	$25,000	$582,825
67	(-6.1%)	$25,750	$318,704	19.6%	$25,750	$666,456
68	(-0.3%)	$26,523	$291,397	18.0%	$26,523	$755,377
69	24.5%	$27,318	$328,694	24.5%	$27,318	$906,202
70	18.0%	$28,138	$354,777	(-0.3%)	$28,138	$875,706
71	19.6%	$28,982	$389,764	(-6.1%)	$28,982	$794,858
72	22.7%	$29,851	$441,613	(-23.1%)	$29,851	$588,250
80	(-23.1%)	$37,815	$181,631	22.7%	$37,815	$790,464
81	(-6.1%)	$38,949	$133,941	19.6%	$38,949	$899,073
82	(-0.3%)	$40,118	$93,572	18.0%	$40,118	$1,013,911
83	24.5%	$41,321	$65,035	24.5%	$41,321	$1,210,566
84	18.0%	$42,561	$26,529	(-0.3%)	$42,561	$1,164,868
85	19.6%	$26,529	$0	(-6.1%)	$43,838	$1,052,361
86	22.7%	$0	$0	(-23.1%)	$45,153	$774,491
94	(-23.1%)	$0	$0	22.7%	$57,198	$976,010
95	(-6.1%)	$0	$0	19.6%	$58,914	$1,097,167
96	(-0.3%)	$0	$0	18.0%	$60,682	$1,223,467
97	24.5%	$0	$0	24.5%	$62,502	$1,445,033
98	18.0%	$0	$0	24.5%	$64,377	$1,376,948
99	19.6%	$0	$0	(-0.3%)	$66,308	$1,230,356
100	22.7%	$0	$0	(-6.1%)	$68,298	$893,562
Avg	6.5%	$654,451	$0	(-23.1%)	$1,511,552	$893,562

Source: Manulife Investments

Returns for Portfolio A are annual returns of the S&P/TSX Total Return Index, repeating a seven year period (June 2001 to June 2007) and do not include any fees or Management Expense Ratios (MERs). For Portfolio B, the returns are reversed. The sequence of returns has an average compounded annualized return of six and a half per cent over the respective periods. The accumulation portfolios assume a starting value of $200,000 at age 51 with no annual withdrawals. The distribution portfolios assume a starting value of $500,000 at age 65 as well as a five per cent first-year withdrawal, thereafter adjusted for three per cent inflation annually.

In this scenario, where Client B is dependent on retirement income from the portfolio, the order of returns is critical to the success of the overall plan. With the better returns coming at the beginning of the period, over twice the income was withdrawn from the portfolio and the client has over $800,000 remaining to pass on to beneficiaries.

Overall, it is important for individuals and families who are planning for retirement to take into account both good and bad environments. The sequence of portfolio returns that occur early in retirement can have a long term effect on the success of a retirement plan. Please contact us at 256-704-5111 if you have any questions.

Note: The techniques and strategies above are intended to provide accurate information regarding the subjects covered; however, they are furnished with the understanding that neither BlueCreek Investment Partners, LLC nor the author are engaged in rendering legal, or tax professional advice or counsel. BlueCreek encourages the reader to seek competent professional counsel to address any legal or tax issues that may arise.