Pouring or Drinking?
Historical return numbers reported in your 401k investment menu have little to do with how much wealth you would have accumulated over that period, as these returns ignore the impact of systematic contributions or withdrawals.
→ Sequence risk has to do with the relationship between volatility of returns and your personal timeline of building or spending wealth to fund goals. Investors should understand and have a process to deal with sequence risk if they are to successfully navigate accumulation and distribution stages of managing their wealth.
Wealth, not Returns
Whether your portfolio is half-full or half-empty depends on your perspective….are you pouring funds in (working and saving), or are you drinking from it (spending in retirement)? If you use a 401k as a retirement vehicle, adding money each year to build your nest-egg, things are far from static. You start early in your career with $0. Through regular deferrals, profit sharing and company match, contributions come into the plan and are invested in securities with variable returns. Working professionals often accumulate a large percentage of their retirement wealth inside these plans, many becoming millionaires or multi-millionaires over the course of their careers.
Growing
Consider the following example. Over the twenty-five year period from 1990 to 2014, the average total return of the S&P 500 was 9.6% per year. How much wealth would a 40-year old executive accrue by age 65, contributing $25,000 per year and increasing that amount by 3% per year under the following return scenarios: 1) 9.6% each year (No Variation), 2) actual returns of the S&P 500 from 1990 to 2014 (Calendar), 3) returns of the S&P 500, but in an ascending order (Worst-to-Best) or 4) returns of the S&P 500, but in descending order (Best-to-Worst):
Chart Title
What’s happening here? Compound annual growth rate (CAGR) in each scenario is 9.6%, but ending wealth is different—and dramatically so! Remember, the CAGR calculation ignores the impact and timing of contributions. CAGR, however, remains the standard metric for how returns are reported in financial publications, such as prospectuses or marketing summaries. This is because the investment manager has no control of how much or when you contribute. An internal rate of return calculation (IRR) incorporates the timing of cash flows and reflects a true measure for the level of final wealth.
The best performing scenario, in terms of final wealth and highest IRR, is Scenario 3. Why is this so? We reordered the sequence of returns to start low, when our 40-year old has very little money at risk, and returns increase to the end of our time horizon, when the majority of their wealth benefits from a winning streak of double digit return years. Paradoxically, what’s good for an early career saver, can be devastating for a recent retiree. Poor returns early in retirement subject a portfolio to losses at a time when there’s no further contributions to shore up values. In retirement, investors look to satisfy a relatively known set of future spending plans with assets that fluctuate in value—that is if the assets have a variable return as stocks do. A late career professional or recent retiree would actually prefer the best returns to come early, when most of their capital benefits from strong returns, and have poor returns at the end of their retirement horizon. ⬎
Considerations
Here’s all you have to do. Start your investing career in a bear market and retire at the beginning of a long bull market and things will work out just fine! Since investors cannot control when their own timeline matches up with the realities of markets, what are best practices to deal with sequence risk? First and foremost, investors should focus on managing wealth and look beyond standard returns, as we’ve illustrated here. The best way to do this is to first quantify long-term goals—how much you’re likely to need and when you’ll need it. If investors have a goal, then it becomes much easier to appropriately measure progress towards that goal. Pension plans measure their funded status, which simply tells them how much in assets they hold relative to future spending obligations. Begin to view investment decisions through a similar lens.
“There is a fair amount of research stating that markets exhibit persistence in returns over the short-term, followed by longer-term mean reversion.”
Once goals are quantified, determine an appropriate mile marker for where you need to be in a shorter increment of time, such as 3-5 years. As things inevitably happen outside of your control, close monitoring helps to identify these issues. While there are some easy “actuarial” adjustments you can make to fix any problems on paper (such as delaying retirement, lowering your retirement goal, or—be extremely careful with this one—assuming higher future investment return) there are more substantive things, such as increasing your savings, that will actually mean doing something in order to course correct.
Finally, one area to consider is allowing your portfolio asset allocation to adjust to these internal as well as external market developments. There is reason to consider this approach if long-term returns from financial markets are (at least approximately) forecastable. If markets are a pure random walk, where today’s price tells you nothing about tomorrow’s returns, this would offer little or no profit. There is, however, a fair amount of research stating that markets exhibit persistence in returns over the short-term (the momentum effect), followed by longer-term mean reversion (the value effect). If an investor implements this kind of allocation methodology, the portfolio would own a lower percentage of stocks when prospective returns are lower, and a higher percentage stocks when prospective returns are higher. This could have a positive effect on the level of wealth over the investment and increase the IRR calculation.
This post has addressed the risk of varying returns in light of accumulating and distributing wealth, known as sequence risk. This together with market risk constitute the two primary risks to retirement planning. While sequence risk is getting the right returns in the wrong order, market risk is simply not getting the right returns. In other words, what if the market doesn’t produce expected returns over an investor’s time horizon—i.e. what if long-term is not long enough? The issue of how to deal with market risk has been addressed in several prior write-ups, but we will spend more time on this risk in future posts. ⬥
Investment advisory services provided by Forward Wealth Management, LLC. Past performance may not be indicative of future results. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.