Addressing Sequence of Return Risk
Impact of Combination of Withdrawals, Inflation, and Timing
In two previous blog posts we discussed the impact of “curveballs” upon retirement planning.
The first curveball was the impact of timing in the post “Timing is Everything? Or is It?” We explored how the success or failure of an investment plan is due in large part to when an initial investment was made, a seemingly random variable. Over the time horizon analyzed, the ending value of a $100,000 investment in the S&P 500 Index after ten years could have been as high as $209,470 or as low as $87,006, based solely upon when the individual made the initial investment (Source:Zephyr StyleADVISOR).
- Take-away is that if you can’t predict it, it makes it very difficult to plan for it.
The second curveball is the impact of taking withdrawals from an investment plan, discussed in “Suffering From Withdrawals?” As investors shift from the accumulation to distribution stages of their life cycle, the negative consequences of large bear markets become much more pronounced. Market drawdowns are no longer opportunities to “buy on a low.” Instead, retirees are forced to liquidate their holdings during times of market weakness.
- Take-away from that post is withdrawing funds from a sinking market makes it all the more difficult to recover losses.
In this blog post, we combine these two analyses into what we call a “WIT Analysis” - in other words, exploring the combined impact of withdrawals, inflation, and timing on an investment.
How an investment plan might look after a decade in the real world, if a retiree is forced to take withdrawals and had the bad luck of investing at the wrong time.
Source: Swan Global Investments
Again, we assume an initial investment, this time $1,000,000 to reflect a retirement account at point of initial distribution, in one of three options:
- the S&P 500 Index;
- the Swan DRS Select Composite or;
- the Morningstar Target Date 2000-10 category average*.
Each investment is made for ten years, starting on January 1st. The results are “rolled forward” yearly, meaning the first investment period extended from 1/1/98 to 12/31/07, the second investment period is from 1/1/99 to 12/31/08, etc.
However, rather than assuming a simple buy-and-hold for each of those decades, we introduce the idea of taking out withdrawals, adjusted for inflation.
At the end of each year we take out $50,000, adjusted for a 3% inflation rate. In addition, we added the most recent decade of 1/1/06 to 12/31/15. How do our three investment options stack up?
* Note — You cannot invest directly in either the S&P 500 or the Morningstar Target Date 2000-10 category average. The S&P 500 was selected as a broad proxy for the U.S. equity market. The Morningstar Target Date 2000-10 was selected as a proxy for those target date funds deemed suitable for someone in or near retirement the decade of 2000–2010.
Source: Zephyr StyleADVISOR
After ten years and $573,194 of withdrawals, the average investment in the S&P 500 still had a remaining value of $828,524. However, that average masks a lot of variability.
The “best case” scenario, an investment made on January 1st, 2003, had an ending value of $1,250,045.
The “worst case” scenario was an investment made on January 1st, 2000. That unlucky investor was subject to not one but two major bear markets. Forced to take withdrawals in the down years of 2000, 2001, 2002 and 2008, the pool of capital remaining was only $303,027 at the end of 2009.
The average target date fund of the vintage 2000–2010 had very similar ending values as the S&P 500, but with less variability between best and worst.
The Swan DRS posted the best results of the three.
The average ending value after a decade, taking out the same $573,194 of withdrawals, was $1,397,189. There was little dispersion between the best decade and the worst decade, with values of $1,535,377 and $1,263,360, respectively. Full results are below:
Source: Zephyr StyleADVISOR
These results support the prime objective of the Defined Risk Strategy: to strike the right balance of upside participation during bull markets and downside protection during bear markets.
Since its inception in July 1997 the DRS has successfully navigated through three bull markets and two bear markets.
We are often asked, “What is the appropriate time horizon in which to measure the DRS’s performance?” Our answer to that question is always a full market cycle, meaning one that incorporates a bull and a bear. Each of the decades in this WIT analysis contain at least one bull and one bear market.
These issues are explored in-depth in a paper called “The Retirement Conundrum: Untying the Gordian Knot.”
About the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.
Important Notes and Disclosures:
Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes non-qualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. Swan claims compliance with the Global Investment Performance Standards (GIPS®). All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970–382-8901 orwww.swanglobalinvestments.com. 037-SGI-020916