Friday, September 27, 2013

Lifetime Sequence of Returns Risk

Individuals face sequence of returns risk throughout their investing lifetimes. Though one may invest over a 60 year period, for example, the returns they experience in each of those years will have different impacts on their lifetime financial outcomes. 

This is a short blog post which picks up on the themes of my recent post about how "You Can't Control When You Are Born."

In this example, someone earns a constant inflation-adjusted salary and saves a constant percentage of this salary each year over a 30-year period. In retirement, they withdraw a constant inflation-adjusted amount over a 30-year period. The lifetime investing cycle lasts 60 years. The analysis is based on Monte Carlo simulations with 100,000 60-year periods with returns averaging 7% with a 20% standard deviation.

What the following figure shows is how much each year's return impacts the financial planning outcomes.  For the first 30 years, what we see is the percentage of the final wealth accumulation at the retirement date which can be explained by the investment return experienced in years 1-30. What we observe is that with wealth so low at the beginning, the early returns have very little impact on the final result. A given percent change in the portfolio value does not have much impact on the absolute amount of wealth accumulated at the end.  It is the returns experienced at the end of the 30-year period which have the biggest impacts on the final wealth accumulation, as this is when a given percentage change in the portfolio value has the biggest impact on absolute wealth. Individuals are especially vulnerable to these returns as they approach their retirement date.

For years 31-60, we switch from accumulation to distribution, and I am showing the impact of each year's return on the maximum sustainable withdrawal rate experienced by retirees.  The return in year 31 is the return for the first year of retirement, and the result in this first year explains more than 14% of the final outcome for retirees. Retirees are very vulnerable to what happens just after they retire. This result holds even more so in the real world when we consider how human capital plummets at the retirement date, as it becomes increasingly difficult to return to the workforce.  Sustainable withdrawal rates are disproportationately explained by what happens in the early part of retirement. The returns experienced in the last 10 years (years 51-60) have very little impact on how much one could sustainably withdraw over retirement.

And so with this figure, we can see a clear demonstration of the lifetime sequence of returns risk.