Protecting Your Retirement Assets

By Andy Mayo AAA

Risk of ruin in finance can mean the probability of bankruptcy or, in the case of a retiree, outliving one's assets. A retiree who can generate all the annual income he needs from a cash/fixed income portfolio doesn't have to worry about risk of ruin. But even a bond portfolio faces reinvestment risk if a higher interest-paying bond matures when interest rates are lower. At that point, buying a new bond won't generate the same income. That may pinch the retiree, but it won't ruin him or her.

See: Retirement Planning

However, a retiree's real risk of ruin comes from stock market volatility and the retiree's need to liquidate assets periodically for income. Withdrawals taken during down or flat market cycles create a risk of ruin just like a string of losing trades for an active trader.

The way to avoid risk of ruin is the same for the retiree and the trader: start with enough capital to withstand a string of losses. To do so, you have to estimate the probability of future returns and the rate of inflation. Read on to find how.

The Sequence Of Returns
The greatest danger for someone in or planning on retirement is relying on this scenario - using one period of market performance as a guide. For anyone liquidating assets periodically, what's important isn't just the rate of return, it's the sequence of returns.

For 17 years, beginning in 1966, the market was flat and had the highest inflation on record. Few if any financial advisors or stockbrokers use that period for their illustrations. According to William Bernstein's book "Four Pillars of Investing" (2002) the reason is simple: No asset allocation avoids bankruptcy when a 4% withdrawal rate is applied to a $1 million portfolio using returns from that time period.

The 4% withdrawal rate used by many financial advisors is no guarantee. Illustrations using an average annual return, even for a long period of time, are especially dangerous. Actual annual returns are hardly ever average. In 54 of the 82 years between 1926 and 2007, the Standard & Poor's 500 Index (S&P 500) performance was either a loss or a gain of more than 20%. In other words, almost 66% of the time, the index returned better or worse than a return of between 0% and 20%. Only one-third of the time did the index performance fall within the range of an "average" 10% return (0% to 20%).
An average annual return is irrelevant. It's the sequence of returns that's important.

For example, over the 17-year period (1987-2003), the S&P 500's average return was 13.47%. It doesn't make any difference if we look at the returns from 1987 to 2003 or from 2003 to 1987.

But when taking withdrawals, the sequence of returns makes all the difference. The same initial capital, the same withdrawal amount, the same returns - but a different sequence produces dramatically different results.

For a $100,000 portfolio taking $10,000 a year adjusted for 4% inflation over those 17 years, the difference is a remaining balance of $76,629 to a deficit of $187,606. The following table illustrates the dramatic difference in return that occurs by inverting the rates and putting 2003's performance first and 1987's last.

Year Portfolio Value - Beginning of Year Value After $10,000 Inflation-Adjusted Withdrawal Rate of Return Portfolio Value -Year End
1987 100,000 90,000 5.25% 94,725
1988 94,725 84,325 16.61% 98,331
1989 98,331 87,515 31.69% 115,249
1990 115,249 104,000 -3.11% 100,766
1991 100,766 89,067 30.47% 116,206
1992 116,206 104,040 7.62% 111,967
1993 111,967 99,314 10.08% 109,325
1994 109,325 96,166 1.32% 97,435
1995 97,435 83,750 37.58% 115,223
1996 115,223 100,990 22.96% 124,177
1997 124,177 109,374 33.36% 145,862
1998 145,862 130,467 28.58% 167,754
1999 167,754 151,744 21.04% 183,671
2000 183,671 167,020 -9.11% 151,805
2001 151,805 134,488 -11.89% 118,497
2002 118,497 100,488 -22.10% 78,280
2003 78,280 59,550 28.68% 76,629
Average Annual Return: 13.47%
Year Portfolio Value - Beginning of Year Value After $10,000 Inflation Adjusted Withdrawal Rate of Return Portfolio Value -Year End
2003 100,000 90,000 28.68% 115,812
2002 115,812 105,412 -22.10% 82,116
2001 82,116 71,300 -11.89% 62,822
2000 62,822 51,574 -9.11% 46,875
1999 46,875 35,177 21.04% 42,578
1998 42,578 30,411 28.58% 39,103
1997 39,103 26,450 33.36% 35,274
1996 35,274 22,114 22.96% 27,192
1995 27,192 13,506 37.58% 18,581
1994 18,581 4,348 1.32% 4,406
1993 4,406 0 10.08% 0
Average Annual Return: 13.47%

What's striking about this result is that three years of negative returns at the beginning of the withdrawal sequence completely negate the positive returns of the best bull market anyone in retirement is likely to experience in the future: Performance for 1995-1999 was +37.6%, +23.0%, +33.4%, +28.6% and +21.0% respectively. It is unlikely that we will see that kind of winning streak again for quite some time.

Regardless of those four consecutive years of great returns, the portfolio drops to $4,348 after the tenth year's withdrawal – the point of ruin.

Outliving Your Savings
Clearly, a key issue for a retiree is the condition of the market at or very early in retirement. If it happens prior to retirement, a delay of a year or two may dramatically reduce the risk of ruin. If it happens in retirement, some action is required, such as part-time employment or reducing one's cost of living.

Risk of ruin brings to the forefront the following concepts that every investor should be thinking about before making any decisions about retirement.

  • Accumulated capital is critical - Beware of financial product illustrations that front-load good performance years.
  • An investor's focus has to be on periodic, cumulative returns - Average returns are to be ignored in favor of cumulative returns. What's critical is the amount of money an investor has at the end of each year from which he or she must raise spending money for the coming year.
  • Avoid fixed costs - Spending flexibility is perhaps the most important thing a person can do to avoid outliving assets. Work to keep income needs flexible during periods of adverse market conditions. Flexibility depends on fixed costs. Carrying a mortgage or other debt into retirement imposes a fixed cost that can be deadly when the market turns down. Flexibility demands a no-credit, cash budget.
  • Tactical asset allocation - Is desirable in order to avoid significant losses in any given year. Strategic (or static) asset allocation through periods of adverse market conditions and persistent portfolio withdrawals will increase the chance of ruin. Investors have to think "loss avoidance" and that means overcoming the "sunk cost" obstacle. Take the small loss before it turns into a big one. It takes only an 11% gain to get back to even after a 10% loss. It takes a 33% gain to recover from a 25% loss. Time is not on the side of an investor taking withdrawals.

Risk of ruin can be an antidote for the rules that guide investors during the wealth accumulation phase. For a long-term investor, market risk is accepted as a given, because the long-term positive performance of the market takes care of that problem. But an investor liquidating principal can't depend on the long term. As such, the retiree has to know, for any given year, the maximum market loss that can be absorbed to still have money to live on in the coming year.

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