As a follow up to the previous post:
Here’s the Skinny…
Risk-Managed Accounts May Subdue Sequence of Returns Risk (Part II)
Risk-managed accounts are my first line of attack (my second will be discussed in Part III) against the sequence of returns risk for investors withdrawing retirement income from their accounts.
In Part I, we analyzed a scenario in which investors had a nest egg of $1,000,000 and were attempting to take annual withdrawals beginning at $60,000 and increasing each year by 3% adjusting for inflation. The problem was, depending upon the sequence of their returns, (1) one ran out of money, (2) another had a declining balance, and (3) the third maintained their $1,000,000 nest egg after withdrawals. Mathematically these are all accurate and true. That’s the unusual challenge with sequence of returns risk – it depends on the luck of the draw.
So, do we just throw up our arms and pray the sequence of returns works in our favor? Of course not.
The looming retirement planning question is “How may we prepare in real life?” Can we do anything to combat this risk besides simply withdrawing less money? Well, let’s address the ultimate stress-test… Let’s hypothetically look at what would have occurred to investors in the midst of the 2008-09 financial crisis.
We will compare and contrast relevant numerics for the S&P 500 Index alongside a risk managed account from USA Financial Portformulas, using the Sector Bull-Bear Strategy.
Here’s what performance and accumulation look like if we simply assume that both the S&P 500 and the Sector Bull-Bear Strategy have $1,000,000 invested and are allowed to accumulate with no withdrawals from 2004 through 2016:
I’ll attach a PDF brochure for the Sector Bull-Bear Strategy if you would like to know more details specifically about how the model functions. Suffice it to say here, the Sector Bull-Bear is a formulaic trending risk managed model that uses specific criteria to select amongst 11 sector ETFs for the S&P 500 via “sector trigger scores,” but then also calculates an overall “master sector trigger” to formulaically dictate when the model will shift entirely out of equities to a conservative bond/gold ETF blend.
The chart above illustrates the S&P 500 (the GREY line) versus the net fee performance of the Sector Bull-Bear (the BLUE line) from the beginning of 2004 through 2016. Take particular note of how the Sector Bull-Bear would have responded during the 2008-09 financial crisis by automatically shifting out of equities – revealing the popularity of using risk management.
But remember, we are discussing the perils of the sequence of returns risk and the difficulties it creates when distributing retirement income withdrawals from a portfolio.
So next, we will extract withdrawals just as we discussed in Part I of this write-up.
In the chart below, we will use the identical investment of $1,000,000 and identical performance from the chart above. However, now we will assume that the investor begins to immediately withdraw $60,000 per year, via monthly income checks, increasing each year by 3% to adjust for inflation.
In this chart, the GREY line still represents the S&P 500 with ZERO withdrawals, just so you have a point of reference. But our real focus is now on the green and orange lines. The GREEN line represents the S&P 500 less the withdrawals (again, beginning withdrawals at $60,000/year paid monthly and increasing 3% annually for inflation). Notice the severity of the decline during the 2008-09 financial crisis and the fact that by 2016 the GREEN line is running consistently below the initial investment of $1,000,000.
The ORANGE line represents the Sector Bull-Bear less the same withdrawals (again, beginning withdrawals at $60,000/year paid monthly and increasing 3% annually for inflation). Once more, focus your attention on the reaction of the ORANGE line during the 2008-09 financial crisis. Also, follow the ORANGE line movement through 2016 as it remains significantly above the initial investment of $1,000,000 through the duration. This is the value of using risk management to combat the sequence of returns risk!
Unfortunately, all I ever read about the “acceptable retirement withdrawal rate” and/or the “sequence of returns risk” is that one must reduce their retirement income. It’s as if everyone forgot what investment planning was all about. Risk management is why we exist! Anyone can simply identify a 60/40 portfolio allocation and reduce income payments from 6% down to 3%; there’s no need for a financial advisor in a relationship based on that math.
But financial advisors exist to deliver value to their investors. And risk management is one of the primary ways that such value may be delivered… Especially to an investor in need of withdrawing retirement income.
That’s the Skinny,
Mike Walters, CEO
The performance illustrated in the comparison charts above use back-tested performance. Back-tested performance involves the application of an investment strategy to past market data and conditions. The results do not represent actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight. The results posted in this illustration should not be considered indicative of Portformula’s skills since money was not being actively managed during the referenced time period and Portformulas was not providing investment advice. Client accounts will follow the strategies that generated these back-tested results, however, these results may not reflect the impact that any material or market or economic factors might have had on Portformulas’ use of the back-tested model if the model had been used during the period to actually manage client assets.
Returns for any strategy utilizing back-tested returns are calculated using the most recent month-end closing price for each holding chosen for the new period. Back-tested returns further assume trading was executed on the first business day of the month and therefore, as stated, do not reflect actual trading. Actual trading occurs on or near the beginning of the month, but not necessarily the first of the month. Due to market performance, fluctuations may occur after the first of the month but prior to the actual trade date. Accordingly, actual results for investors who were invested in a Portformula strategy during the same time period may have been higher or lower than the results for the period listed in this illustration.
The back-tested performance referenced herein is based on time-weighted returns. Because Portformulas published time-weighted returns, all advertised performance data reflects performance after advisory fees have been deducted. Time-weighted returns show the compound growth rate in a portfolio while eliminating the varying effect created by cash inflows and outflows by assuming a single investment at the beginning of the period and measuring market value growth or loss at the end of that period.
Due to market volatility, current performance may be higher or lower than the performance shown. Investment may be purchased or sold without regard to how long you have owned them. Frequent movement can result in tax implications. This illustration utilizes the S&P500 index because it is a well-known index and provides a recognizable frame of reference. Indexes such as the S&P500 are not publicly available investment vehicles and cannot be purchased.
Important Notice: Portformulas is an SEC-registered investment advisor. SEC registration does not imply a certain level of skill or training. Investing carried an inherent element of risk and the potential for substantial loss in principal and income exists. Portformulas (the Firm) operates with limited discretionary authority to engage solely in the implementation of specific step-by-step investment criteria and account rebalancing as indicated and selected by the client. This activity is generally referred to by the Firm as a Portformula Investment Strategy. You should only invest in Portformulas upon receiving and reading the Portformulas ADV. SEC File No. 801-67442.