How to invest for retirement: limit the risks you face when retiring in a bad economy.
Think back to primary school. Remember the commutative property of multiplication? It’s the one that states that, when multiplying, you can swap the order of the numbers being multiplied without changing the result. For example,
5 x 3 x 8 = 120, and 8 x 5 x 3 = 120.
Investment returns are multiplicative and, therefore, subject to the commutative property of multiplication.
For example, imagine that you invest $1,000 in a mutual fund, and it earns the following returns over the next five years:
-8%, -20%, +3%, +15%, +32%
The end result will be the same, no matter the order in which the returns occur. But when do returns make a difference?
When Order Does Matter
If, however, you were to invest $1,000 each year in that mutual fund, then the sequence of returns would matter (because our math now includes addition as well as multiplication). For example, if the returns occurred in the order listed above, you’d have $6,803 at the end of the five years. But if they occurred in the opposite order, you’d only have $4,437.
As you can see, when you are dollar cost averaging and systematically adding money to an investment, the returns that occur at the end of the sequence are the ones that matter most, because you’ve invested the most money by that point. Conversely, when you’re systematically taking money out of an investment portfolio, the early returns (i.e., the ones that occur while you still have a lot of money invested) are the ones that matter most.
Do You Feel Lucky?
In other words, for most investors, the returns that occur shortly before and after retirement are of vital importance. How your portfolio performs during those ten or so vital years can make a dramatic difference to your quality of life in retirement.
You’ve probably seen this play out in the lives of people you know. People who retired around 2004-2005 (whose vital decade has been one of roughly zero returns in the stock market) tend to be in much worse shape than those who retired a decade earlier, in the middle of a stock market boom.
The scariest thing about what financial professionals call “sequence of returns risk” is that there’s not a heck of lot you can do about it — you have precisely zero control over how the market performs over a particular handful of years. It’s just plain luck.
Minimizing the Role of Luck
One response is to plan for the worst. That is, work to accumulate a portfolio large enough to pay your bills with an extremely low withdrawal rate. If you can pay your bills with a withdrawal rate of 3% or less, you’ll probably make it through retirement just fine regardless of when the market chooses to perform for you.
A second approach — the one I personally plan to use — is to annuitize a portion of your portfolio. By purchasing an annuity (specifically, a single premium immediate fixed annuity) you can lock in a withdrawal rate for the rest of your life, thereby eliminating the risk of living too long or getting unlucky with the timing of returns.
About the Author: Mike Piper writes at Oblivious Investor, where he provides plain-English explanations of topics like Roth IRA rules and income tax brackets.
Copyright © 2010 The Digerati Life. All Rights Reserved.
{ 12 comments… read them below or add one }
While it is best not to try and time the market, this article brings up some very valid points. To take it a bit further, there are also certain days of the year if you invest you will do better than others. If you catch the market on a down day when your 401K auto draft hits, you make a few extra dollars than if it hits a day later.
Personally, while I think there is benefit to be in the market, the article hits on a key point – recurring income. Something like an annuity or even rental income provides cash flow outside your 401K or IRA. However, think about that early rather than later. Let’s say you buy a rent house when you are 40 and manage to pay it off when you are 65. That could mean an extra $1000 per month in retirement income.
Mike a really good post. The sequencing of returns is so very critical to retirement success. This is one of the factors that makes retirement planning so challenging. One thing that I and a number of my NAPFA colleagues often do with folks in retirement is to layer the portfolio so that there is always sufficient liquidity to avoid having to sell equity assets in a down market. As for the idea of using a single premium fixed annuity for part of your retirement, while I am not so much opposed to this I would urge folks to shop very very carefully here.
BasicMoneyTips: You’re right, retirement planning really does come down to ensuring (or perhaps insuring) that your income needs are satisfied.
Roger: I’m curious about your statement to be careful when shopping for a fixed SPIA.
I absolutely agree that it’s important to check the financial strength of an insurance company before buying an annuity from them. Also, it’s wise to stay within the limits for your state’s guarantee association. Is there something else you’d suggest being careful about?
The scariest thing about what financial professionals call “sequence of returns risk” is that there’s not a heck of lot you can do about it — you have precisely zero control over how the market performs over a particular handful of years. It’s just plain luck.
The mathematics points made early in the article are important and right on.
However, I really wish that my old friend Mike (I am banned from participating at Mike’s blog but I do think of him as a friend — we had lots of good times during the days when I commented there almost daily) would stop saying things like the words quoted above. Are you sure that investors have “zero control” over their returns and that its “just plain luck”? If you’re not sure, I wish you would say something like “there are some who believe that it might be plain luck” or something like that.
I’ve studied the historical stock-return data in great depth for over eight years now and I have not been able to find a single time in history when returns were “plain luck” or beyond investor control. If you know the valuation level that applies on the day you purchase an index fund, the numbers show that your 20-year return is 78 percent predictable. I think it would be fair to say that returns are 22 percent luck. But we have control over the 78 percent factor (we can invest less heavily in stocks when high valuations assure poor long-term returns).
The point here is that retirees don’t have to worry about investing in stocks when prices are reasonable. And everyone — not just retirees — needs to worry when prices are where they have been since 1996.
I hope it’s okay if I say that I miss you, Mike, I wish that I could be talking these things over with you more regularly. I hope things have been going well with you since we last talked. I’m happy when I see your name appear at one of the blogs at which I participate.
Rob
An alternative or complimentary strategy is to focus on income well ahead of your actual retirement date.
If you start shifting your portfolio into income producing assets (including dividend paying stocks or investment companies, REITs and real estate) then you don’t face so much volatility on the actual day/period when you come to retire.
In the Hilton Head Real Estate market we have a large portion of our yearly buyers who are either retired or 2-3 years from retirement. Over the past few years we’ve seen a lot of hesitation in this segment…some have taken massive hits in the market. Others have lost or had greatly reduced their recurring incomes…many have had small/side business that they have had to either sell at a loss or simply shutter. Interesting article…love the blog.
In order to make sure my nest egg last, I was planning on using the “plan for the worst” method by accumulating a portfolio large enough to pay my bills and using a low withdrawal rate of 3-4%. However, after reading your blog post, I will look into the idea of purchasing a single premium immediate fixed annuity to lock in a withdrawal rate that will last for the rest of my life. Seems pretty stress free, provided I manage the withdrawal amount and make it enough to live off of. Thanks for this info!
You make a very good point. Many folks are great at saving money, but are not that good at turning that money into a reliable, steady source of income. Annuities are a good potential strategy, unfortunately they can very complex and convoluted, with many traps for the unwary investor.
This is a really important post on issues that are sometimes swept under the table. Over the past 20 years the S&P 500 is up over 8%/year on an average annualized basis. The problem is that the last 10 years haven’t been that great. If you flipped the 10 year periods around it would be completely different.
Commenters make 2 really important points. First, it is not just a matter of reversing the accumulation procedure when you get into retirement and start drawing the nest egg down. Retirees need to avoid liquidating equities and bonds for that matter in down markets! As an aside there is a danger of the later in the future as individuals are piling into bonds. If interest rates push significantly higher there will be a big surprise 2 to 3 years down the road.
The second point that has been alluded to is that when you retire is important. If you open up the paper and see that the S&P 500 has reached an all time record and turn to your wife and say “honey I think we have enough to retire on now” you could be making a big mistake. Another way to say this is it is better to retire after the market has gone through a rough period. For example, if you can afford to retire today you are probably in pretty good shape.
It’s a very good point that you can’t control what happens in those ten years, but you can do quite a bit. The annuity is one great step as mentioned. Good diversification across asset classes (stocks, bonds, real estate, commodities, etc…) and global markets would seem like another wise move.
Lastly, I’ve found that my websites are returning cashflow that is relatively consistent over the last 3 years. True this is similar to an annuity, but it’s one that can be built with some sweat equity instead of your money. I believe that is a great hedge, to standard investing practices.
Most investments can be good — it’s a matter of timing and what is good for a particular person. I strongly recommend professional advice. I’ve been in the investment business for nearly 30 years, but at every meeting with my advisor, I learn something new.
Today, most investors are bruised from equity market risks over the past 12 years of no nominal growth and 30% negative loss in real purchasing power. They are looking for guaranteed return investments–or at least something with a guaranteed of principal.
Wade Dokken
The crystal ball that tells us all what investment will be “hot” in 10, 20 or 30 years would be priceless. Best bet is to stay diversified, dollar cost average and hope you retire somewhere “hot”!