How Sequence of Returns Can Kill Your Retirement Before You Even Get Started
Friday, February 16, 2024
How Sequence of Returns Can Kill Your Retirement Before You Even Get Started
Friday, February 16, 2024
Mitch Zaba
Sequence of returns risk is a wealth killer.
Especially for those in the first 3 years of retirement.
It would be nice if we could rubber stamp our 6% average every year without any fluctuations. Investing would be a peaceful, stress-free journey.
But that isn’t the case. Quite the opposite.
Some years you're up 20% and others you're down the same.
At times, investing can put a lot of pressure on the old pacemaker that not even the sleep apnea machine can keep you sleeping.
Thankfully, history has proven for 100 years that there are more good years than bad years.
But what happens if you’re so unlucky that your bad investing years happen early in your investing journey? Or in the first few years of retirement?
Well, it’s kind of like going surfing for the first time and getting bit by a shark.
Horrendous luck but you lived to tell the tale.
Here is How Shark Bites Apply to Math
Consider these three investors all achieving the same 4.8% rate of return on $500,000.
- Shooter has a good start with a bad finish
- Virginia has a steady return and
- Happy has bad start with a good finish
As you can see, it takes Happy (bad start) the full 10 years of frustration to catch up to his colleagues.
However, if Happy and Shooter were invested the exact same and Happy started just before a recession, Happy would always have less than Shooter.
How bad is the sequence of returns for retirees?
Very bad.
If we take this same scenario and withdraw $50,000/year. Happy runs out of money while the other two are still able to play golf.
That’s because withdrawals compound the effect of negative returns.
I call this a terminal loss.
Because it’s money you’ll never be able to recoup without taking on extreme risk going forward and that’s what casinos are for.
How can you minimize the sequence of return risk in retirement?
The challenging part of funding retirement is getting the maximum amount of return with the least amount of risk.
There are lots of strategies to accomplish this but only a few that are effective.
- Keep Your Money In Cash - High Interest Savings Accounts and Money Market funds have had a resurgence lately because prime rates in Canada have skyrocketed for the time being. But that part is expected to be short-lived. Not to mention inflation is still ticking above 3% so this option has a net return of less than 2%.
- Invest in GICs- Guaranteed Investment Certificates have become popular again with higher interest rates.
- Invest in Bonds - Bond rates are similar to those of GICs with one exception. Bonds have the ability to achieve capital gains as well as interest income. A bond can be sold to another investor at a higher price than you purchased it which allows for capital gains on top of the interest you already earned.
Unfortunately, bond rates were so poor for 20 years that they weren’t a great option to generate income for retirees. - Buy An Annuity - An annuity is great if you know you’ll live past 85. In this option you transfer a significant lump some of your retirement savings to an insurance company in exchange for a guaranteed monthly income until the day you die.
When running projections for annuities, we find that break even points are beyond 18 years. Meaning, if you die before 18 years of retirement, you will be worse off. Secondly, annuities do not provide any estate value to your beneficiaries.
In addition, I would argue that CPP and OAS are annuities. With the right strategy you can build up some nice guaranteed income from these two options.
Option 5 - The Trusty 60/40 Portfolio
According to Vanguard, “The annualized return for the 10 years through 2022 was 6.1% for a globally diversified 60/40 portfolio.” (That is 60% Equities and 40% Fixed Income.)
Even after a loss of approximately 16% in 2022.
And after 12 years in business, if there is one thing I’ve learned it’s that clients don’t like losing money even if their 10-year average is 6.1%.
Losing money sucks.
In fact, it sucks so much that Tony Robbins, in his book “Unshakeable: Your Financial Freedom Playbook” states that losing money triggers the exact same fear emotion as GETTING EATEN BY A LION.
Imagine that.
The same response to your impending death by a lion is triggered when the stock market is falling.
Does that seem entirely logical?
Not really.
But we are not logical people. We are highly emotional.
That’s why we need to focus on limiting losses.
Because there are plenty of years in the stock market where you will think you’re being eaten by a meat-eating lion.
Here are 4 risk metrics you should look for in your retirement portfolio.
Consider these two similar portfolios.
| Asset Details | Asset details as at 31/12/23 | Asset details as at 31/12/23 and 30/11/23 |
|---|---|---|
| Canadian Equity | 17.66% | 24.14% |
| US Equity | 25.95% | 25.21% |
| International Equity | 15.91% | 11.82% |
| Fixed Income | 39.64% | 34.64% |
| Cash | 0.11% | 4.26% |
| Other | 0.72% | -0.07% |
They both have similar weightings to equities and fixed income.
The only difference is the underlying investments within each portfolio.
And they have the following risk metrics. There are 4 to zero in on.
- Beta - One measurement of volatility. How much your portfolio swings up and down relative to the market. A number close to 1.0 means your portfolio will have similar swings as the market. A number less than 1.0 means your portfolio won’t be as crazy as the market.
- Standard Deviation - Measures the variance in returns over a set period. You could have 2 portfolios with the same average rate of return however one does +40% and -20% returns whereas the other does +10% and -3%. The lower the standard deviation, the fewer swings you can expect in your portfolio.
- Maximum Drawdown - Measures the maximum loss the portfolio experienced from its previous high.
- Upside/Downside - Measures relative to the industry average, or benchmark, how much of the upside and downside your portfolio realizes. Ideally, you want greater than 100% upside and 0% downside but that would be a unicorn and unicorns don’t exist.
Conclusion
The markets periodically teach us why sequence of returns matter to your retirement plan. A proper portfolio needs to consider your income goals, inflation risk, longevity risk, and downside risk so that you can minimize the effects of sequence of returns.
Hi, I Am Mitch Zaba
Over the past 10+ years, we've worked closely with clients showing them how to grow their wealth, pay less taxes and how to create predictable passive income in the stock market.
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