Solving the Lifetime Income Challenge: Which returns will you see in retirement?
October 8, 2009
Last week, Putnam CEO Bob Reynolds delivered an important address on a topic many investors neglect to consider: the risks posed by the sequence of returns they’ll see once they retire.
A lucky investor might see positive returns in the years right after retirement. These positive returns can help raise an account’s value enough to afford a comfortable stream of income and even the possibility of leaving a substantial legacy. An unlucky investor would be someone who sees negative returns upon retirement. This unlucky sequence of returns can cause irreparable damage to a portfolio even when the negative returns are followed by positive returns.
Risk in the Sequence of Returns: The $1 Million Portfolio
There’s risk inherent in any sequence of returns. We think of it as the chronological equivalent of a lottery ticket. To illustrate the differences between lucky and unlucky investors, we’ll use a hypothetical, all-equity portfolio of $1 million and 20 years of historical returns for the S&P 500 Index (1989 to 2008).
This investor retired in 1989 and his timing was wonderfully lucky. Riding the boom times of the late 1990s, his portfolio saw positive early-year returns and grew at a healthy rate. It even achieved returns over 37% in 1995.
In these illustrations, returns are represented by the S&P 500 Index. Example assumes a $50,000 withdrawal in year 1, increased by 3% in each subsequent year to adjust for inflation.
These illustrations are hypothetical and are not indicative of any fund or product.
Retiring in 1989 turns out to have been wonderfully lucky. Riding the boom times of the late 1990s, the lucky portfolio saw positive early-year returns and grew at a healthy rate. It even achieved returns over 37% in 1995.
If our lucky investor withdrew a prudent 5% a year to fund retirement (increasing by 3% annually for inflation) his portfolio would have returned more than $1.3 million in income over 20 years. At the end of 20 years, the portfolio’s balance would be over $3 million.
2008-1989: The Unlucky Investor
A Reversal of Fortune
But suppose we reverse the sequence of returns so that they run from the historical market decline of 2008 to the post-9/11 downturn and then to 1989?
The average yearly return over the period would be the same 10.36%. But the outcome is completely different because the returns now start with losses. In this example, by making the same initial withdrawals and inflation adjustments, the unlucky investor is flat broke after 19 years. He’ll draw $1.1 million in income from the original $1 million portfolio.
Hedging the Sequence-of-Returns Risk:
The Unlucky (but Smart) Investor
Since we can never know which return sequence we’ll get in retirement, how do we protect against an unlucky sequence? One effective technique is to limit losses – and gains – by employing a hedging strategy.
In this example, the investor faces the same unlucky sequence of returns we just saw. But he has an advantage: a smart financial advisor who creates a “collar,” or two-way hedge strategy, around his $1 million portfolio. Using puts and calls, this strategy both caps the upside at 17% and limits losses to 10%.
This lets our unlucky investor draw just as much income as the lucky investor — over $1.3 million — and retain a sizeable, $826,000 portfolio after 20 years.
There are risks and transaction fees associated with options strategies. In general, these strategies are not appropriate for individual investors, particularly those in a qualified retirement plan. But in the hands of an experienced financial advisor or portfolio manager, options can be an effective tool at reducing volatility.
Hedging the Sequence of Returns Risk with Absolute Return Funds
Later we’ll look at how a relatively new category of mutual funds managed to limit losses in 2008’s volatile market. They’re the 17 Absolute Return funds tracked by Morningstar, and we’ll also see how they can be employed as an effective component of a hedging strategy to limit risk when taking distributions in retirement.
Asset allocation decisions may not always be correct and may adversely affect fund performance. The use of leverage through derivatives may magnify this risk. Leverage and derivatives carry other risks that may result in losses, including the effects of unexpected market shifts and/or the potential illiquidity of certain derivatives. International investments carry risks of volatile currencies, economies, and governments, and emerging-market securities can be illiquid. Bonds are affected by changes in interest rates, credit conditions, and inflation. As interest rates rise, prices of bonds fall. Long-term bonds are more sensitive to interest-rate risk than short-term bonds, while lower-rated bonds may offer higher yields in return for more risk. Unlike bonds, bond funds have ongoing fees and expenses. Stocks of small and/or midsize companies increase the risk of greater price fluctuations. REITs involve the risks of real estate investing, including declining property values. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. Additional risks are listed in the funds’ prospectus.
Money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other governmental agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in this fund.
Each RetirementReady Fund has a different target date indicating when the fund’s investors expect to retire and begin withdrawing assets from their account. The dates range from 2010 to 2050 in five-year intervals, with the exception of the Maturity Fund, which is designed for investors at or near retirement.
The funds are generally weighted more heavily toward more aggressive, higher-risk investments when the target date of the fund is far off, and more conservative, lower-risk investments when the target date of the fund is near. This means that both the risk of your investment and your potential return are reduced as the target date of the particular fund approaches, although there can be no assurance that any one fund will have less risk or more reward than any other fund.
The principal value of the funds is not guaranteed at any time, including the target date.
