Sequence of Return Risk

A thread to explore the risk that return sequence plays on achieving our financial independence goals.

Historical averages are a good place to start when planning but I want to explore how the sequence of returns might also impact. What happens if we get a repeat of the worst historical sequences at the worst possible times going forward.

 

The numbers I post below are the long term historical average returns I have for the Australian equity market. If they are out - then my yearly data must also be out somewhere.

For the period 1900 – 2016

All stated as geometric returns
Nominal equity 11.8%
Dividend / capital split approx. 50%
Nominal dividend yield 5.9%
Nominal capital growth 5.9%
Wage growth 5.5%
Real return (nominal – wage*) 5.8%

*Nominal 11.8% - Wage growth of 5.5% = 6.3% however the interplay of the two series ends up with a geometric return of 5.8%. for real return.

Good Australian data seems to be hard to get your hands on. Does anybody have any data that can confirm or deny my numbers?

I’m aware that credit Suisse have the 1900-2016 real return for Australia as 6.8% but their deflator is CPI and I much prefer to treat wages (AWOTE) as the deflator the 1% between my real return and Credit Suisse is roughly the long-term difference between CPI and wage growth.

For American historical data, I use this as the source.
Online Data - Robert Shiller

 

You might find this interview interesting:
Michael Kitces – The 4% Rule and Financial Planning for Early Retirement

ASW kindly posted this excellent link to Michael Kitces.


Exploring the 4% rule with my Australian data and applying to my circumstances (because I’m a Narcissist)

i.e. 13 years of accumulation before being able to draw.

The rule states that at commencement of living on your financial capital you can spend 4% of your balance and then increase it at the level of inflation.

For this example, I have 40x (AWOTE) today – I accumulate 13 years and then commence to live off the capital. How much I can allocate to spending under the 4% rule will depend on how much I have in thirteen years which depends on the sequence over the next 13 years. Running the model with all historic sequences I get Income as follows:

Depending on the luck of the sequence the allocation under the 4% rule ranges between .72x AWOTE(real) and 8.77x AWOTE.(real)



(ps the bars that don’t go for the full 43 years are the sequences that don’t yet have 43 years of history. Ie the sequence starting at 1980 will stop at 36, the sequence from 2000 will stop at 16 etc)

So thats the potential allocation under the 4% rule – but can we afford the 4% rule under all Australian historical sequences?



Nope!

All those line diving down are fatal failures. The worst sequence fails just 13 years in. plus there are too many of them for my liking – bad probability. On the upside, the best sequences will see you heirs/charities inheriting upto 1000x AWOTE.

This 4% rule is not dynamic or safe enough for me.

I suspect that it has so many failures because Australia’s inflation history is more volatile than the USA where most of the thinking on this has occurred. Also I am asking the original 4% to keep up with wages which is a much tougher ask than just keeping up with CPI.

Sorry probably confused everybody now – but hopefully you get the jist that sequence of returns has an enormous impact.[/QUOTE]

 

This is the best I found:
http://www.finsia.com/docs/default-...-australian-perspective.pdf?sfvrsn=6b7ede93_2

 

Thanks for the link - excellent.

 

An interesting take, US based but also mentions Canada who's markets are similar to ours

Cash Wedge and Opening the Investment Taps

Daryl on the “cash wedge”:

“When you begin to take income from your investments, the order of the annual returns on your investments makes a big difference. If returns are low in the initial years, the capital base is eroded and that makes it very hard for the portfolio to recover when markets turn back up again. The Cash Wedge Strategy© can assist in minimizing the impact of withdrawing income during volatile markets. Making withdrawals from investments that are volatile can significantly impact your portfolio. Instead, consider adding a Cash Wedge to your portfolio composition so that retirement income is drawn from a more stable source.”

 

Get the timing right and your money is likely to last over the course of your household’s entire retirement. Get the timing wrong and your money, sorry to be the bearer of bad news again, isn’t going to last over the course of your lifetime.

So says Wade Pfau, a professor of retirement income at The American College. In a recent blog post, Pfau ran some numbers, Monte Carlo simulations, to show the effects of what’s called sequence-of-return risk.

You Can’t Control When You’re Born… Revisiting Sequence of Returns Risk

 

Phew been out helping the wife prepare vege gardens for spring planting. Bit stuffed but nearly time for home brew which will aid recovery.

Looks like I've got some reading to do. Will see what I can dig up based on my own research on this recently.

This subject is a very important one and has the potential to involve a lot of discussion given the differing views of experts.

Liability matching has also become somewhat more popular in recent years.

Retirement when it comes is scary for many investors. The fear of outliving ones money even with the Government pension safety net is very real.

This could be a very interesting topic given it is Australia specific. Lots of forums overseas discuss this heavily but is usually US centric.

But more important things first, time for home brew on the deck:

 

Interested to her your thoughts!..... after some recovery.....

 

So it's not 100% that you can live off the passive income forever, luck plays a part.

What about a contingency plan that if the market drops significantly you don't make any withdrawals and you go back to work until the market recovers?

 

If you needed capital/passive income there may be the option to downsize ??

Many factors come into play, Its also dependent on the asset class, income, debt, interest rates, market conditions.

In the main I live off rental income so I am not eroding my capital.

Just because you retire does not mean you have to stop investing, you can still grow capital/income ie developing, buying/selling in rising markets etc etc.

 

This is thread is about living off drawing 4% a year from shares unless I am mistaken.

 

Re go back to work? At the heart of retirement planning is "ratio of investment capital vs human capital". Generally a younger person with plenty of human capital remaining (ability to make money working) can take on a lot more risk than an older person. But this is complicated by behavioural factors.

 

Or for retirees to rent out a room in their home. Just depends how important the age pension is as a factor when earning extra income.

 

Sorry, I got it wrong I thought it was about any asset class.

However, considering its a property forum, my guess is most here will have more $ invested in property and probably retire on this income with a smaller % in SMSF/shares

 

Yes.
I know someone who built 2 g/flats at rear of their property, lives near University, fully contained, always rented, good income.

 

Try not to retire into the headwind of a bear market! And don't give yourself a CPI pay rise in lean years.

But seriously how much cash is enough to mitigate sequence of returns risk? What's everyone working on? 2 - 3 years?

 

The interesting thing I've uncovered so far from my reading is that a crash in the first 2-3 years of retirement is no the issue if following a 4% SWR. The issues really occur when the annual returns on the first decade are lower than expected or a period of rampant inflation.

A great example is the bear market of the GFC which in nominal terms returned to the previous highs within about 3 years.

Further reading here - Understanding Sequence Of Return Risk & Safe Withdrawal Rates

 

The OP is referring to Safe Withdrawal studies typically involving equities and bonds.

But importantly you reminded others here that there are many components that can contribute to retirement income, the world doesn't only revolve around stocks and bonds. Thank you. Government indexed pensions (aged and employer), rental income, dividends, annuities, private employer pensions, interest, realising capital etc all play a role. Some of these either in their entirety or as a percentage based on worst case scenario can be considered to be risk free or very defensive.

The greatest problem is when these safer forms of income fall short of meeting one's retirement living expenses in an extreme negative economic / market environment. That's where these Safe Withdrawal studies / research can play an important role in helping those who are generally less wealthy in particular (the majority likely) hopefully manage to avoid outliving their investments.

 

Great article, I had read it some time ago but really needed the reminder.