2 charts to explain the trade-offs in retirement planning
Investors may need a shift in mindset as retirement approaches but there are ways to structure a portfolio to improve retirement outcomes.
We all struggle with change which makes inflection points a challenging time. In our financial lives one of the biggest inflection points is retirement. There is the challenge of going from work to figuring out what to do with your time. There is the mindset shift from saving to spending.
Yet there is also an underappreciated change in the way we need to think about a portfolio and the way we invest. My advice to younger investors is simple. Invest in growth assets and focus on the long-term and achieving your goal as a mechanism to ignore short-term volatility.
Afterall short-term volatility is simply the price we pay for higher long-term returns. And the more you pay attention to short-term volatility the more likely it is you will do something dumb. That something dumb can be trading too much, chasing performance, ignoring tax consequences, selling at market bottoms, buying at market tops – you get the point. There is a laundry list of stupid things investors manage to do.
The following chart from the Morningstar State of Retirement Income report sums up my advice.
Morningstar Investment Management projects long-term returns and those projections have been applied to a variety of portfolios with different mixes between shares, bonds, and cash. My advice is to invest in growth assets over the long-term because they have the highest projected and historical returns. That is reflected in the 9.41% projected 30-year return for a portfolio that is 100% invested in shares.
Earning that return means accepting volatility. It also means ignoring volatility and not causing it to dictate your decisions. The volatility of each portfolio is reflected in the column on the right. Standard deviation is a measure of the dispersion of returns around the average return. The higher the standard deviation the more short-term returns deviate from the average. Unsurprisingly the 100% share portfolio has the highest projected standard deviation.
The mindset shift in retirement
Successful investors have managed to consciously or sub-consciously embrace my advice. They pick a portfolio mix that is likely to generate the return needed to achieve their goal. And they stick to it during the inevitable volatility and try to limit the mistakes they make along the way.
Approaching retirement things start to change. The following chart from the Morningstar State of Retirement Income Report is indicative of the change. People who have internalised my advice may have issues making sense of this chart.
This chart shows the safe withdrawal rate of different portfolio equity weightings given different time frames of retirement at a 90% success rate. I will explain what that all means. But first we need to understand what is good for a retiree and what is bad.
In the context of retirement, a high safe withdrawal rate is good. A low safe withdrawal rate is bad. The higher the percentage you can safely take out of your portfolio annually the more money you have to spend. We can illustrate this in the 10-year column of the report. If a retirement portfolio has $100,000 in it the safe withdrawal rate for a 100% equity portfolio supports $8,300 in spending. A 20% equity portfolio supports $10,000 in spending.
For investors that have spent their working lives embracing the mantra that more equities are good this can be difficult to understand. This is the change in mindset. To understand why this is the case you need to understand some of the other terms in the chart. But ultimately you are accepting lower expected returns for a higher safe withdrawal rate. That is a tough trade-off to make. But I do have a solution which may provide the best of both worlds. Less of a sacrifice in expected returns while retaining safety.
Understanding the retirement trade-off
My colleague Shani has written a great article explaining the 4% rule which will provide good background on withdrawal rates. Give it a read if you want more information.
The previous chart is based on a 90% success rate. The success rate for retirement refers to not running out of money prior to death. And that does sounds like success to me. Nobody wants to be a geriatric beggar. In this case death is represented by the time frame in each of the column headers ranging from 10 years to 40 years.
Creating this chart involved running something called a Monte Carlo simulation. That is simply running every conceivable retirement scenario and seeing the result. At a 90% success rate the hypothetical retiree did not run out of money in 90% of those scenarios.
In this case a scenario is looking at three factors that impacts how long a portfolio will last in retirement. All of which are unknown. The first is the level of returns. If returns are high there is less of a chance of running out of money. This is common sense.
The second factor is the level of inflation. A safe withdrawal rate is designed to increase each year by inflation to keep standards of living constant. Higher levels of inflation mean more is taken out of a portfolio each year. If more is taken out the portfolio runs out of money sooner. That is also common sense.
The third factor is not common sense which may be why the chart is confusing. While the average level of returns matter, the sequence or order of returns also matters. Low or negative returns early in retirement are bad. They cause a portfolio to run out of money sooner. The reason for this is that assets are being sold off after the market drops early in retirement. You are selling low. A future market recovery will have less of an impact because there are less assets to appreciate in value.
The following two charts are illustrative of the impact of the sequence of returns. In both charts a $500,000 portfolio is 100% invested in the S&P 500 for 20 years. In both charts $20,000 is taken out each year over the 20-year period.
In the first chart I’ve used the actual returns from the S&P 500 starting in the year 2000 in the order they actually occurred. At the end of the period the investor is left with $165,000.
In the next chart I reversed the order of returns. The average returns are still the same. I just swapped the 2019 returns for 2000 returns, the 2018 returns for the 2001 returns, etc. In this scenario the investor has $782,000 at the end of the 20-year period.
The profound difference in outcomes shows the impact of the sequence or order of returns. If you know market history you will remember that the first decade of the millennium wasn’t great for investors. In 2000 the dot-com crash occurred. And then towards the end of the decade the GFC crash occurred. The second decade of the millennium had a strong bull market. Experiencing the poor returns first meant significantly worse portfolio outcomes.
Is there a way to lessen the impact of this trade-off?
This brings us back to the original chart. We can ignore volatility when we are long-term investors. What matters is the average return we achieve over the period we invest. We can’t ignore volatility as we transition to retirement. The 100% equity portfolio that is giving us the highest expected returns with the highest volatility becomes more problematic.
Remember that the Monte Carlo simulation that was run includes every conceivable scenario of returns, sequence or order of returns and inflation scenario. In some of these scenarios the returns are high. In some they are very negative. In many ways this is simply the bad luck of retiring at the wrong time. Luck will always have an impact on our lives. But we want to guard against bad luck derailing our retirement. At the same time, we want to guard against getting too conservative because that will impact our long-term returns.
There are several ways to blunt the impact of this trade-off between returns and volatility in the first years of retirement. An annuity is an example. My preferred solution to this issue is a bucket asset allocation approach. This is the approach I used for my mother when she retired. I will go through that approach in my net article. You can judge this approach for yourself now that you understand the trade-off involved with withdrawal rates and asset allocation.
I would love to hear your thoughts in the meantime. Please email me at mark.lamonica1@morningstar.com