Sequence of Returns Risk in Accumulation

[AdrianC]

Interesting paper on the sequence of returns problem in the accumulation phase.

Who Ate Joe’s Retirement Money?
Sequence Risk and its Insidious Drag on Retirement Wealth

https://www.gmo.com/docs/default-source/research-and-commentary/strategies/asset-allocation/who-ate-joe-s-retirement-money-sequence-risk-and-its-insidious-drag-on-retirement-wealth-.pdf?sfvrsn=20

[forummm]

Sequence of returns risk is terrifying for an early retiree. But for an accumulator (and especially an early retiree), it's really more of a shrug. Yes, it's irritating that you might have to work an extra year at the end of your brief career, but that's a lot easier than running out of money at age 65 with 30 years out of the labor force, and more limited job opportunities. For someone with a really high savings rate, it's the amount you save that matters more for how quickly your stash get to your target than the market performance while you're still accumulating. The authors use 40 year careers as their examples. Those ending portfolio values would be much smaller for someone working for 10 years with a 60% savings rate.

[Retire-Canada]

I don't know about that Forum...FIRE sequence of risk is something that is chiefly a problem in early FIRE and you won't be out of work that long. It's also something that can be mitigated with PT work in poor return years. So I think it's still in the hassle/shrug category after FIRE. It might mean you work the PT equivalent of an extra year or two of FT work, but PT can be a lot more relaxing than a stressful FT job.

If you run out of money at 65 you did a pretty crappy job monitoring your portfolio performance and taking action years ago when you weren't out of work so long.

[forummm]

I don't know about that Forum...FIRE sequence of risk is something that is chiefly a problem in early FIRE and you won't be out of work that long. It's also something that can be mitigated with PT work in poor return years. So I think it's still in the hassle/shrug category after FIRE. It might mean you work the PT equivalent of an extra year or two of FT work, but PT can be a lot more relaxing than a stressful FT job.

If you run out of money at 65 you did a pretty crappy job monitoring your portfolio performance and taking action years ago when you weren't out of work so long.

You're right that post-FIRE SOR risk can be mitigated and is not necessarily catastrophic. Although, the people who are so afraid of the risk of having to go back to work some day that they are planning for a 3% WR or a 98% success rate may disagree with us here.

My point was that pre-FIRE, it's less important (IMO) than post-FIRE.

[Tyler]

Interesting article.  Thanks.

Working longer if markets tank in accumulation isn't really mitigating sequence of returns risk -- it's just dealing with it in a rational way.  It's up to the individual to decide whether needing to work another decade or more for a highly volatile portfolio to recover is the only contingency plan they'd like to consider. 

The linked paper covers value investing which I think this is a perfectly reasonable approach.  However, I believe it takes a lot more talent and effort to do consistently than many people (including professionals) want to admit.  This is especially true when so many other smart people are also looking for the same deals.

My personal preferred approach is to realize that not all portfolios have the same sequence of return risk.  For example, take a look at these two portfolios and consider the width of the cone at the $800k mark. 




Sure, the ones with more uncertainty also tend to have higher average endpoints but that misses the importance of the spread.  The best way to maximize your ultimate portfolio value in the most reliable way possible is not necessarily to ramp up investing risk.  I'd argue that choosing a more consistent portfolio and elevating your savings rate to position the band where you need it to be is the superior choice for many people.  Markets are not in your control, but your asset allocation and savings rate definitely are.  Play around with this calculator for a while, and you'll quickly see that savings rate is a lot more powerful than any risky asset allocation.

[Jack]

Sequence of returns risk in the accumulation phase matters a lot more for normal people than it does Mustachians, because their accumulation phase is much longer than ours and depends on returns (rather than contributions) to a much greater extent.

[Retire-Canada]

Tyler am I reading your charts correctly?

TMS at the end of 28yrs the historical range of portfolio values was between ~$625K- $1.9M

IVY at the end of 28yrs the historical range of portfolio values was between ~$625K- $1.18M

[Tyler]

Tyler am I reading your charts correctly?

TMS at the end of 28yrs the historical range of portfolio values was between ~$625K- $1.9M

IVY at the end of 28yrs the historical range of portfolio values was between ~$625K- $1.18M

Yes, that's correct.  But the lines along the way also tell a story, like the reason you stopped at year 28.  ;)  Looking at all of the 30-year histories, the two portfolios have the same spread of outcomes between ~$700k and $1.4mm.  But one has about a third less volatility, which people concerned with sequence of return risk might appreciate.  Also note that lighter lines are from more recent start periods.  Both portfolios have been hugging the low side of the historical returns range recently, following nearly identical paths.

BTW, I'm not trying to push the Ivy portfolio or anything, and I also think the TSM is a perfectly fine portfolio for many people.  It's just an example to show how some portfolios can have lower uncertainty and still have nice returns.  There are other good options as well with varying degrees of returns and uncertainty, and different plans may call for different portfolios.

[Retire-Canada]

I stopped at 28 years because I didn't understand why there was so much variation at 28 years and so much less at 30yrs. I assumed there might be some end of range affects/issues I didn't understand.

Is my reading of the end of the chart correct?

TMS at the end of 30yrs the historical range of portfolio values was between ~$775K- $1.42M

IVY at the end of 30yrs the historical range of portfolio values was between ~$750K- $1.37M

Can you help me understand why the TSM would give a max of $1.9M at 28yrs and drop to $1.42M 2 years later? Sorry if this is obvious, but I'm not getting it.

[Tyler]

I stopped at 28 years because I didn't understand why there was so much variation at 28 years and so much less at 30yrs. I assumed there might be some end of range affects/issues I didn't understand.

Is my reading of the end of the chart correct?
...
Can you help me understand why the TSM would give a max of $1.9M at 28yrs and drop to $1.42M 2 years later? Sorry if this is obvious, but I'm not getting it.

You're reading it correctly.  And after looking into it, you're right that there's a range artifact with the drop at the far right.  Good call.

The chart superimposes rolling periods with different start dates.  I checked under the hood, and all of the highest peaks are the data points at the end of 1999. That peak doesn't extend all the way to the end of the chart because I only have data counting back 28 years from 1999.  I don't have earlier data, but I'd estimate that the 30-year portfolio starting in 1970 was probably approaching $2mm by the 30 year mark.  Of course, one can also see from the relative line densities how unusual that run was historically and also note how it would soon fall steeply like all of the others. 

I appreciate you questioning the logic of my last post.  I learned something new.  :)

[Classical_Liberal]

The example used in this paper fails to show the end game (i didn't run it either, but can make some assumptions).  Yes, Joe only has 590K vs Janes 880K due to sequence of returns during accumulation.  However,  Joe retires in 1994 and is about to see the biggest market boom... pretty much ever.  While Jane in 2007 is about to see her's get cut by more than 30 percent even with a 50/50 allocation. I would MUCH rather retire with Joe's scenario.  Knowing the future, of course.  In general, one could argue that even if accumulation sequences cut you down with poor returns later in that phase (ie with more accumulated), the same market cycles and mean reversion will help correct this problem later in retirement.  "Dynamic" portfolios is a fancy word for market timing.  The only time I see changing a well researched AA as helpful, perhaps, is to decrease stock allocation slightly (to a more stable asset class) during the first few years of a prolonged retirement. This would help avoid a sequence of returns disaster once the buying stops.  Even then, I would prefer flexibility to changing my AA.

Since no one can predict the future, It's best to use what we do know and that is 4%WR with flexibility is safe provided you keep half your assets in stocks.  3.5% for nervous nellies who will absolutely never work again, want to give lot's upon their death, and believe SSI will dissolve.  Anything more and you have worked too much.

As always Tyler's expertise on AA is appreciated!  Every time you post I play with your tool and get think'en!

[Proud Foot]

While I do agree that the sequence of returns risk is present, I think it is a minor risk and one that can be mitigated*. When you have a retirement date based on age you do rely more heavily on the sequence of returns than someone who has a retirement date based upon asset level.  Unfortunately most people probably have a retirement date based upon age and rely on an advisor of some sort to predict returns and determine how much to contribute each year. The other thing I don't see them mention is what your wr will be in retirement.  The $590k vs $880k doesn't change the success of retirement if the person spends less than 4% of the first number.  Also, as Classical_Liberal pointed out, both Joe and Jane are going to see a big change in their portfolio values the first several years after their retirement.

 * Obviously you cannot chose when you are born which has the largest influence on when you start investing.

[steveo]

Since no one can predict the future, It's best to use what we do know and that is 4%WR with flexibility is safe provided you keep half your assets in stocks. 

The thing is the 4% WR is 95% safe. If you know that target and hit it then you should be okay.

[AdrianC]

Since no one can predict the future, It's best to use what we do know and that is 4%WR with flexibility is safe provided you keep half your assets in stocks. 

The thing is the 4% WR is 95% safe. If you know that target and hit it then you should be okay.

The 4% WR was 95% safe. That's all we can say for sure.

From where we are now stocks and bonds are likely to return lower than historical averages. It's unfortunate for those of us FIREing now, but that's the way it is. Plan accordingly.

[Retire-Canada]

From where we are now stocks and bonds are likely to return lower than historical averages. It's unfortunate for those of us FIREing now, but that's the way it is. Plan accordingly.

Just to remind us all the 4% SWR was predicated on a 1% fee hit on the historical returns. Most of us are paying 0.2% or less so you already have nearly a 3% SWR in comparison to that study data and its results.

Looking back on what the historical FIREr had to live through in the past that was covered by Trinity Study data I am more than happy to FIRE now. I feel like we are living in a pretty sweet time to be a human with a fat investment portfolio and a lot of time off to spend doing things I want.

I don't share the pessimism about the 4% WR, but my FIRE plan is so deeply risk mitigated as MMM and others point out that I am confident even an unusually bad run of returns will not cause me any horrible problems.

[Tyler]

Just to remind us all the 4% SWR was predicated on a 1% fee hit on the historical returns. Most of us are paying 0.2% or less so you already have nearly a 3% SWR in comparison to that study data and its results.

You're probably thinking of the more recent research by Wade Pfau that is particularly pessimistic about the 4% rule but assumes a large fee. The original Trinity study did not account for fees.

http://retirementresearcher.com/trinity-study-updates/

[Retire-Canada]

You're probably thinking of the more recent research by Wade Pfau that is particularly pessimistic about the 4% rule but assumes a large fee. The original Trinity study did not account for fees.

http://retirementresearcher.com/trinity-study-updates/

My bad. Thanks for the correction Tyler.

[steveo]

Since no one can predict the future, It's best to use what we do know and that is 4%WR with flexibility is safe provided you keep half your assets in stocks. 

The thing is the 4% WR is 95% safe. If you know that target and hit it then you should be okay.

The 4% WR was 95% safe. That's all we can say for sure.

From where we are now stocks and bonds are likely to return lower than historical averages. It's unfortunate for those of us FIREing now, but that's the way it is. Plan accordingly.

I don't agree with the negative comments in relation to valuations and a SWR. Is this really a bad time ? The Internet, cheap index funds, a fairly stable world economy etc.

I think most people seem to be aiming for 4% plus the ability to add in some flexibility. I personally think that is as safe as you can possibly get and I'd be willing to declare FIRE earlier than that.

[sol]

The 4% WR was 95% safe. That's all we can say for sure.

Technically, it was 100% safe in all but 5% of the tested start years.  Very much not the same thing.

So your caution about your expectations of future returns needs to be put into that context.  If you think current valuations are worse than all but 5% of the market's history, then a 4% SWR might fail.  That's very different odds than you stated, and totally unrelated to low bond rates or whatever worries you.  The global economy was literally blowing itself to pieces with global war for more than 5% of the market's history.

[AdrianC]

Looking back on what the historical FIREr had to live through in the past that was covered by Trinity Study data I am more than happy to FIRE now. I feel like we are living in a pretty sweet time to be a human with a fat investment portfolio and a lot of time off to spend doing things I want.

Oh, I agree. Not complaining at all.

I don't share the pessimism about the 4% WR, but my FIRE plan is so deeply risk mitigated as MMM and others point out that I am confident even an unusually bad run of returns will not cause me any horrible problems.

And I'm the same way. Lots of options.

This should be uplifting:

If You Can: How Millennials Can Get Rich Slowly
William J. Bernstein (2014)
https://dl.dropboxusercontent.com/u/29031758/If%20You%20Can.pdf

Page 8:
"a portfolio that is two thirds stocks and one third bonds should have a long-term expected real
return of around 3%"

"The average person needs to accumulate about twenty-five years of living expenses,
and I’m assuming you’ll be getting about half of that from Social Security."

[AdrianC]

So your caution about your expectations of future returns needs to be put into that context.  If you think current valuations are worse than all but 5% of the market's history, then a 4% SWR might fail.  That's very different odds than you stated, and totally unrelated to low bond rates or whatever worries you.  The global economy was literally blowing itself to pieces with global war for more than 5% of the market's history.

I'm not worried. But I am realistic. Current valuations are higher than almost all of the Trinity studies' data set.

The CAPE ratio is currently higher than in 1965. Currently at 26, 1965 it was about 24. Prior to the internet bubble, CAPE has only been higher than now during one time period - the bubble and crash in the 1920s.

Bonds are currently at or close to negative real yields.

http://www.gocurrycracker.com/the-worst-retirement-ever/

"Pure 4% withdrawals for a retirement starting in 1965 were a disaster, with the portfolio dropping to $0 in about 25 years.  This occurred regardless of asset allocation.  A portfolio of 50% stock / 50% bonds failed just as surely as a portfolio of 100% stock."

But none of us are going to blindly continue pulling out 4% (or 5%) in a bad market, are we? We all build in many safeguards and have many options, don't we?

[arebelspy]

The 4% WR was 95% safe. That's all we can say for sure.

Technically, it was 100% safe in all but 5% of the tested start years.  Very much not the same thing.

So your caution about your expectations of future returns needs to be put into that context.  If you think current valuations are worse than all but 5% of the market's history, then a 4% SWR might fail.  That's very different odds than you stated, and totally unrelated to low bond rates or whatever worries you.  The global economy was literally blowing itself to pieces with global war for more than 5% of the market's history.

Huh.  For some reason, this clicked a better understanding into place.  I like the way you put that.  Thanks, sol.