Sequence of Returns Risk
Coping with the Uncertainty of Investment Returns
Imagine that you have been putting away $10,000 at the beginning of each year from 2002 until 2019. For the sake of this example, taxes and commissions are excluded; you have been investing that money into the Canadian stock market for which XIC, the iShares Core S&P/TSX Capped Composite Index ETF, will serve as a proxy. Over that 18-year period annual returns averaged 8.55%. Your investments at the end of 2019 were worth $369,038.52, which is significantly more than an average of 8.55%, simply because you kept on investing, year after year, whether good or bad.
Table 1, below, indicates the end-of-year return for each year as indicated. The $10,000 at the top of the Balance column indicates the annual amount contributed at the beginning of each year and the remaining balance figures represent the end-of-year balances.
Retirement Withdrawals
Scenario 1: Same Sequence of Returns
Continuing our scenario, let’s assume you are retiring and now want to withdraw those funds. You want the withdrawals to last for the same 18 years that it took for you to build up the balance of nearly $370,000. Since the average return each year was 8.55% you figure that would be a good percentage to use.
Plugging in 8.55% of $369,038.52 equals $31,552.79. Let’s assume that the sequence of returns is the same for the next 18 years as it was for the previous 18. Table 2 presents the outcome.
A straightforward 8.55% doesn’t work. Just as your return was much greater than your contributions, the same sequence means that your withdrawals still leave you with over $100,000 remaining at the end of 18 years.
In fact, in order to exhaust your assets in 18 years, you must increase your withdrawals to $34,511.73, as Table 3 indicates.
Scenario 2: Best-Case Returns
Let’s imagine now that you had the same average return over the 18-year period, 8.55%, but that your returns were frontloaded so that your best returns came in the earliest years and your worst returns came at the end. Table 4 illustrates this scenario. You can withdraw $65,947.83 per year and not run out of money.
Scenario 3: Worst-Case Returns
Finally, let’s imagine the same average return of 8.55% but that your worst returns are frontloaded and your best returns only come in the final years. Table 5 illustrates this. The good returns at the end are simply unable to overcome the bad start. In order to make your money last, you can only withdraw $14,784.10 per year.
Strategies to Avoid Worst-Case Outcomes
Diversify
As you can see, over the course of 18 years, although the Canadian stock market averaged 8.55%, in certain years it deviated significantly from that return. In fact, it never hit 8.55% at all, although in 2017, it did get close at 9.05%. One way to resolve these wild gyrations is to temper your high and low returns by adding some fixed income investments, like bonds or GICs. Neither of them are paying much in the way of interest right now, but they can still protect you against a persistent bear market that lasts for two years or more.
Although stock markets can go on for years without providing a meaningful return, if you plan to keep on investing for 10 or more years, the probability is that you will grow your assets faster with equities than with fixed income.
Having said that, you may want to give serious consideration to reducing your risk by increasing your allocation to fixed income as retirement approaches and then keeping it low for the first few years after you commence retirement.
To illustrate this, take a look at Table 6, which shows the same performance as in Table 1, the historical performance of the Canadian stock market as represented by XIC, except that for the last five years, instead of 100% being invested in XIC, a 50/50 mix of XIC and XBB is invested (highlighted in grey). XBB is the ticker symbol for the iShares Core Canadian Universe Bond Index ETF, which gives holders “broad exposure to the Canadian investment grade bond market.” As the last five years, from 2015 to 2019, had quite good performance the 50/50 portfolio does underperform the all-equity account almost $25,000. You only have $344,590.38 accumulated. However, we did not know what your performance might be for the next five years in 2014.
Now let’s go back to our worst-case scenario, which was illustrated in Table 5. However, in this case, shown in Table 7, you carry on with the 50/50 portfolio (again highlighted in grey) for the first five years because withdrawing during a bear market can be particularly damaging to your long-term returns. Thereafter you return to your all-equity account that contains only XIC. Despite having almost $25,000 less in accumulated assets, switching to a 50/50 portfolio during your first five years of retirement results in the ability to withdraw $23,051.39 every year, rather than $14,784.10, a difference of $8,267.29.
Alternative Diversification Strategies
There are various ways in which you can reduce your risk of a poor investment return. All of them, however, involve some form of diversification away from an all-equity (all-stock) investment portfolio.
Annuities
Annuities are insurance products that are typically arranged to provide a guaranteed payout for as long as you live. For example, just as you are about to retire, you approach a life insurance company with $100,000 of your retirement money and receive in return, a contract in which you are promised $480 per month (an estimate based on online sources) for the rest of your life. You may want to spend a little more than $100,000 to get the guaranteed income you are seeking but once you have you have a guaranteed income to cover your fixed expenses, you gain the flexibility to withdraw less from your other retirement investments.
Cash Reserves
Instead of mixing your stock investments with fixed income, you could always set aside some of the money in cash or cash-like holdings so that in a bad investment year, you simply draw from your cash rather than sell your stock holdings. However, since those cash reserves are not participating in the stock market, you may be losing in terms of the growth of your investments.
Bucket Strategy
This approach involves determining how much you need from your investments each year and then refilling it when it is spent. For example, assume that beyond CPP, OAS and a modest pension from your employer, you need an addition $20,000 per year from your investments. In that case, you would hold $20,000 in a savings account, from which you would draw during the current year. Behind that would be four different GICs, with maturities of 1 through 4 years. The balance would be in your presumably higher earning but riskier portfolio. See the table on the left.
Each year, you would spend down your cash balance. Your shortest-term GIC would mature which you would use to replenish your cash balance, and the other GICs would all move one year closer to maturity. You would then sell off $20,000 (or the appropriate inflation-adjusted amount) from your riskier portfolio and use that to buy another 4-year GIC. That way you always have five years of safe money available, which allows you to take more risk in your investment portfolio in the hope of greater long-term gains.
Risk and Return
In order for there to be a greater probability of earning significant returns from your investments, you need to take some degree of risk. For most people these days, that means investing in the stock market. But, that doesn’t mean you should take more risk than necessary, particularly around retirement, when you are no longer able or willing to sustain your spending by being employed. Taking some care and caution with your portfolio as you begin to withdraw from it, can make a significant difference to whether you will be able to enjoy your retirement as you hope.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax or legal decisions.
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