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Why Does Everyone Experience Such Different Retirement Income Outcomes? - Retirement Researcher
4/17/17, 10:12 AM
Why Does Everyone Experience Such Different Retirement Income
Outcomes?
by Wade Pfau, Ph.D., CFA
April 10, 2017
Individual investors are vulnerable to the sequence of market returns experienced over
their investing lifetimes. Individuals who behave in exactly the same way over their careers
—saving the same percentage of the same salary for the same number of years—can
experience disparate outcomes based solely upon the specific sequence of investment
returns that accompanies their career and retirement.
Click here to download more of Wade’s tips on managing retirement risks.
Peak vulnerability is reached at the retirement date, when returning to the labor force
becomes increasingly difficult and a post-retirement market drop can be devastating.
Actual wealth accumulations and sustainable withdrawal rates will vary substantially
among retirees, as these outcomes depend disproportionately on the shorter sequence of
returns just before and after the retirement date.
In other words, individuals are the most vulnerable when their wealth is likely the largest it
has ever been, in absolute terms, due to the sequence of returns. Two investors may
enjoy the same average return on their investments, but could still experience divergent
outcomes based on the sequence in which returns arrive.
This can impact both those who are saving and contributing to their portfolio, and those
who are withdrawing a constant stream of cash flows from their portfolio.
Historical simulations based on overlapping periods reveal how sequence of returns can
create differing outcomes for otherwise identical investors. We’ll look at the life of one
individual investor we’ll call Adam.
The only unknowns Adam faces with regard to his retirement planning is what his specific
sequence of market returns will be. This simplifies reality, as Adam is not saddled with
uncertainty in his future employment status and salary.
Adam saves for retirement during the final thirty years of work, and he earns a constant
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Why Does Everyone Experience Such Different Retirement Income Outcomes? - Retirement Researcher
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real income in each of these years. For thirty years, he puts away a fixed savings rate of
15% of his income at the end of each year.
The wealth accumulation achieved at retirement is defined as a multiple of Adam’s
constant real salary. In other words, if the wealth accumulation is 10x, then Adam had
savings equal to 10x times his salary upon reaching retirement.
A $100,000 salary means a $1 million portfolio. In this simplified world, Adam does not
worry about health risks, disability, or potential involuntary job loss. He can continue work
over the next thirty years earning a constant inflation-adjusted salary.
Adam retires at the start of the thirty-first year, and his retirement lasts thirty years.
Withdrawals are made at the beginning of each year during retirement. The withdrawal
amount is defined as the percentage of retirement date assets withdrawn (e.g., 4%), and
this amount adjusts for inflation in subsequent years.
The maximum sustainable withdrawal rate over thirty years is the initial percentage of
assets withdrawn in the first year. That amount is adjusted for inflation in subsequent
years, and the portfolio balance reaches zero at the end of the thirtieth year of retirement.
For simplicity’s sake, portfolio administrative and planning fees are not charged, and taxes
are not deducted.
The historical characteristics for the 50/50 portfolio include a 5.6% real arithmetic mean,
volatility of 10.7%, and a real compounded return of 5.1%. If the historical average
compounded return could be fixed at 5.1% without volatility, a 15% savings rate for thirty
years would result in retirement date wealth equal to 10.1 times salary.
Exhibit 1 shows the historical wealth accumulations based on actual rolling periods of the
historical data. Though Adam could expect (on average) a wealth accumulation equal to
10.1x his salary, the historical outcomes ranged from a minimum of 5.2x if he retired in
1982 to a maximum of 17.4x if he retired in 2000.
Despite saving in the same way from identical salaries and using the same 50/50 asset
allocation, one Adam was able to save more than 3.3 times as much as the other. These
are very different outcomes, again, for individuals who otherwise behaved in identical
ways and were only exposed to a different sequence of market returns during their
working years.
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Why Does Everyone Experience Such Different Retirement Income Outcomes? - Retirement Researcher
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Exhibit 1
Wealth Accumulation After a 30-Year Career
50/50 Asset Allocation, 15% Savings Rate, Inflation-Adjusted Salary
Using SBBI Data, 1926-2016, S&P 500 and Intermediate-Term Government Bonds
Retirement Researcher 2017
Wealth Accumulation After a 30-Year Career
Even individuals whose careers largely overlap may still experience different outcomes.
For instance, retirees in 1973 and 1975 had twenty-eight of their thirty working years
overlap, but the 1975 retiree reached retirement with 36% less real wealth than the 1973
retiree.
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William Bernstein, in his 2012 ebook, Ages of the Investor, used waterfalls to describe the
large drops in wealth accumulations that may follow wealth peaks, explaining how some
individuals might unwittingly just miss their opportunity to reach their wealth target after
thirty years, and subsequently may find that working for much longer does not get them
back to where they had hoped to be.
This is sequence of returns risk in the context of the accumulation phase, as people are
more vulnerable to the returns experienced when their portfolios are larger. A given
percentage change has a bigger impact on absolute wealth, and a large drop in the
portfolio value could counterbalance all of the capital gains earned for most of the early
part of your career.
The sequence of returns problem occurs even more harshly for retirees using a constant
inflation-adjusted spending strategy. With compounded returns of 5.1%, a retiree could
expect to withdraw 6.3% of their retirement date assets, adjust this for inflation, and have
their wealth last for precisely thirty years.
But because of return volatility, the actual maximum sustainable withdrawal rates vary
greatly over time. In Exhibit 2, sustainable withdrawal rates from the rolling historical data
ranged from 4% (in 1966) to 9.8% (in 1982). The variance between these sustainable
withdrawal rates is based simply on the luck of the draw regarding the post-retirement
return sequence.
Exhibit 2
Sustainable Withdrawal Rate Over a 30-Year Retirement
50/50 Asset Allocation, Inflation-Adjusted Spending
Using SBBI Data, 1926-2016, S&P 500 and Intermediate-Term Government Bonds
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Retirement Researcher 2017
Sustainable Withdrawal Rate Over a 30-Year Retirement
Next, Exhibit 3 attempts to give a clearer picture of how sequence of returns risk impacts
both the accumulation and distribution phases. The exhibit is based on statistical
regression analysis, which determines how much of the outcome (wealth accumulation or
sustainable withdrawal rate) can be explained by the returns experienced in each year of
the lifecycle.
The exhibit isolates the impact of each year’s return on lifetime outcomes using a larger
sample of 100,000 Monte Carlo simulations based on a 50/50 portfolio with the same
characteristics as the historical data. For the first thirty years (when individuals are
saving), the percentage of the final wealth accumulation at the retirement date grows
from year one through year thirty.
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With wealth accumulations at insignificant levels in the early part of one’s career, the early
returns have very little impact on the absolute level of wealth accumulated at the end of
the savings period.
But as retirement approaches, a given percentage return produces an increasing impact
on the final wealth value in absolute terms, leaving individuals particularly vulnerable to
these later returns. Simply put, later market returns impact more years of contributions.
In years thirty-one through sixty, during the retirement distribution phase, the exhibit
shows the impact of each year’s return on the maximum sustainable withdrawal rate. The
return in year thirty-one represents the first year of retirement; this initial return explains
almost 14% of the final outcome for retirees.
Retirees are extremely vulnerable to what happens just after they retire. This result would
hold even more so with the human capital considerations of the real world, as it is
increasingly difficult to return to the workforce after you retire. Sustainable withdrawal
rates are disproportionately explained by what happens in the early part of retirement.
Returns from later in retirement have minimal impact as the outcome for that retirement
(high or low sustainable spending) was already set in motion earlier.
Exhibit 3
Lifetime Sequence of Returns Risk
50/50 Asset Allocation, Inflation-Adjusted Spending
100,000 Monte Carlo Simulations Based on SBBI Data, 1926-2016,
S&P 500 and Intermediate-Term Government Bonds
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Retirement Researcher 2017
Lifetime Sequence of Returns Risk
Sequence of returns risk affects individuals throughout their entire investing lives.
Individuals from different birth cohorts who otherwise behave in identical ways may
experience dramatically different wealth accumulations and sustainable withdrawal rates.
These outcomes are unpredictable.
Strategies using a volatile portfolio to target a wealth accumulation goal or to sustain a
constant spending strategy expose individuals to much greater risk than you might expect
when thinking about an average return that might apply to someone investing over a
sixty-year time horizon.
Retirement Researcher is owned by McLean Asset Management Corporation (MAMC),
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to be reliable. There are many different interpretations of investment statistics and many
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