From Wade Pfau:
You Can't Control When You're Born... Revisiting Sequence of Returns Risk
My aim is to put together some thoughts based on reading Dirk Cotton’s recent posts on sequence of returns risk at his “The Retirement Cafe” blog, William Bernstein’s excellent e-book The Ages of the Investor, as well as some of the issues I discussed in my article on “safe savings rates” and a follow-up about "getting on track for retirement" from a few years back.
Dirk Cotton clarifies that sequence of returns risk is something which can apply both in pre-retirement and post-retirement. Two investors may enjoy the same average return on the investments in their portfolio, but may still experience very different outcomes if they experience a different sequence for when these returns arrive. This can impact both those who are saving and contributing to their portfolio over time, and those who are withdrawing a constant stream of cash flows from their portfolio during retirement.
Let’s illustrate this in a simplified world to make this vulnerability very clear and prominent. Americans are a very self-reliant people who believe if you work hard and do what you are supposed to be doing, then things are going to work out. So let's consider some hypothetical individuals who are doing everything absolutely right (based on our state of knowledge) with regard to their retirement planning. When retirement is still 30 years off in the horizon, they begin saving 15% of their salary at the end of each year.
In our simplified world, these folks don’t have to worry about health risks, disability, or economic shocks to Main Street which might cause them to lose their jobs. They are able to continue work over the subsequent 30 years earning a constant inflation-adjusted salary.
As well, unlike in real life, there is no uncertainty with regard to investing. There is risk, but this risk is understood. Each year the market provides a 7% real return on average, but the actual return is going to fluctuate around this real return with a standard deviation of 20%. So while one does not know what the year-by-year returns will be, they do know that returns will fluctuate around 7%, and with 30 years of returns the average (arithmetic) return each investor earned over their career will be somewhere close to 7%. Their wealth will not compound at this rate, as with volatility a given percentage drop in the portfolio requires a larger percentage gain to get back to where they started, and the math shows that the compounded growth they can expect for their portfolio is 5% (7% - 0.5 * (20%)^2).
So these folks play by the rules, do everything right, don’t experience any health or unemployment issues, and understand the underlying return process that affect their portfolios. Saving 15% at the end of each year and with wealth compounding at 5%, they fully expect to reach retirement with a portfolio equal to 10 times their salary.
Where do they actually end up?
The following figure shows a Monte Carlo simulation of a time series chart for 151 hypothetical investors who work and save for 30 years and get 30 years of market returns, but who differ only in which 30 year period they worked and saved in this 180 year simulated historical time frame.
Though they could expect wealth equal to 10x their salary, the outcomes ranged from a minimum of 2.98x to a maximum of 27.7x. The median accumulation was 9.9x and the mean was higher at 11x. These are very different outcomes for people who otherwise behaved exactly the same. What’s more, we see cases like how 10 years after the person retired with 27.7x, the subsequent retiree only had 8.7x. This is despite the fact that 20 years of their respective careers overlapped. What’s more, the person retiring only one year later than the fellow with 27.7x only had 17x their salary. This despite the fact that 29 years of their 30-year careers overlapped with one another. With William Bernstein’s idea of waterfalls, some of those folks with the lower wealth accumulations might have just missed their chance to reach their wealth target after 30 years, and might find that they don’t get to where they had hoped to be with even 50 or 60 years of work.
This is sequence of returns risk! People are more vulnerable to the returns experienced when their portfolios are larger because a given percentage change has a bigger impact on absolute wealth. A big portfolio drop at the end could possibly wipe out all of the portfolio gains from the first 25 years of one’s career....MORE
