Where is my retirement money?
Let me explain using two fictional employees – Mike and Jacob. They worked for Megacorp Inc and were identical in all aspects of their job. They both started working at age 25 and both worked for 40 years. Their salary and salary growth were identical, along with their Kiwisaver contributions. They made the same investments with their savings during which they both earned exactly the same returns of 5% after inflation and fees.
At the end of their 40-year careers, Mike had $700,000 in his retirement account, while Jacob had $450,000. Jacob is $250,000 worse off even though they made the same decisions. If they both experienced the same rate of investment returns, how is this possible?
Sequence of returns risk
One key factor I left out in my fictional example was that Mike started his career in 1965, while Jacob started in 1975. So, even though Mike earned the same return as Jacob, he received it in a different sequence, and that made all the difference. Sometimes the difference between good luck and bad luck can only be 1 or 2 years.
The problem with retirement calculators
And that is the problem with retirement calculators. If you input 5% returns into an investment calculator it will tell you how much you will have after 40 years. One single figure. It ignores the sequence of returns completely, which can have a significant outcome on your savings.
I input the following figures into an online savings calculator:
Original principal $0
Annual addition $5,000
Years to grow 40
Investment return 5% (80% invested in stocks)
The calculator says I will have exactly $636,350 in retirement.
If I input the same figures into my calculator that factors in 1000 different sequence of returns scenarios, we get a range from $510,000 if we are 10% unluckier than the median returns to $810,000 if we are 10% luckier than the median returns. The median figure is $605,594. This is the result of just one random sequence of 1,000 scenarios over 40 years.
You will notice that my median figure is not too dissimilar to the number from the online calculator, however it also considers the range. The sequence of returns risk is very real and we must acknowledge its presence. Although we would never get the bottom or top numbers in the range, we can get a good idea of what the top 10% and bottom 10% results would look like. I for one, don’t like leaving anything to chance so I always consider the worst-case realistic scenarios in my planning to pressure test the strength of my plans.
The difference in my median number and most online calculators is that they often take average return of investment. Whereas my calculations use the more reliable average named the compound annual growth rate, or CAGR for short. It sounds much more complicated than it is and I will illustrate the difference between the two averages with an example:
In 2 years of investing Kim has enjoyed a 10% average return per annum. Her original investment was $1,000. Using the average, Kim’s return in year one was $100 (10% of $1,000). Year two would have seen a return of $110 (10% of $1,100). Kim’s 2-year return was $1,210 using the simple average that online calculators use.
Although the 2 years enjoyed a 10% average return, they were very contrasting years. Year one saw a drop of 10% and year two saw an increase of 30%. Using the CAGR, Kim’s return in year one was -$100 (-10% of $1,000). Year two’s return was $270 (30% of $900). Kim’s 2-year return using the more accurate CAGR method of calculation was $1,170.
$40 difference no big deal right? Not so fast. If that $1,000 investment becomes a $500,000 investment, then we are looking at $10,000 per annum differences. Just from a 2-year sequence. This is an extreme scenario of going from -10% returns one year to plus 30% the following year but it illustrates the point. Imagine if we first had 3 negative years in a row. We just need to be careful with how we are calculating our retirement numbers because it can be the difference between retiring with enough money and not having enough.
Cashflow matters – how can we have enough?
Sequence of cashflow matters in both the accumulation (saving) and decumulation (withdrawal) phases.
In the accumulation phase, if you get good returns early in your career and bad returns later in your career when your balance is higher, you will be much worse off that someone who experiences the opposite.
In the decumulation phase sequence risk is very important to be considered as part of your planning. The opposite of the accumulation phase is true. If the market returns are low or negative in your early retirement years and high at the end of your retirement when your balance is lower, you will be much worse off than someone who experiences the opposite.
A lot of this may sound like good luck or bad luck. To some degree it is. It is not our fault we were born 10 years later. We can’t just accept our fate though. We can still try and soften the impact through our own preparedness.
How can I prepare for a market downturn near retirement?
A lot of people that have heard of sequence risk and are aware of its impact, still decide to do nothing. They see it as just an unfortunate problem. It exists, but there is nothing we can do about it. If you have been saving for 30 years or so then that is a lot of money to leave to chance. Crossing your fingers that there is not a market downturn shortly after you retire. I recommend that you plan for a downturn then you will not be so unprepared if it happens. You can reduce the sequence of return risk in the following ways.
1/. Reduce your exposure in stocks or other high-risk assets
Invest more in safer investments, such as bonds. This is a catch 22 because having a percentage of your portfolio in stocks is your best bet if you want your money to last for a 30-year retirement. But I also understand how hard it can be to lose a large chunk of your portfolio in the first few years of retirement. It can be hard to recover from. If you are risk averse in retirement then having all your cash or in treasury bonds or something similar may sound nice and safe but if you are doing this then consider inflation.
For example, if your bonds are returning 3% return, but inflation is at 2%, your real return is only 1%. This means you shouldn’t be drawing more than 1% per annum from your retirement portfolio. This will only work if you have a very large portfolio. For those with more realistic (lower) nest eggs, then you will still need to keep a portion in higher yielding investments. I recommend a mix of stocks and bonds depending on your risk appetite and how much money you have saved.
2/. Dividend investing
Investing in shares that pay good dividends will ensure a steady stream of income. New Zealand companies attract international investors because of their relatively high dividend yields. Companies in New Zealand usually pay dividends twice per year. If you can find stable companies with a good track record of paying dividends you are likely to receive healthy dividends.
Dividends often operate independently of share price so even if market prices go down, dividend pay-outs can often remain. So, if you are earning 4% after tax returns and withdrawing 4% of your money for expenses, then you can spend without dipping into your original portfolio balance, relying solely on the dividends. This is a great hedge against a declining portfolio.
3/. Annuities
Annuities take away all the risk of outliving your nest egg. Great if you are risk averse. Your nest egg is turned into guaranteed lifetime income. This is a new offering in New Zealand and Lifetime Income Ltd (Incorporated in December 2015) appear to be the only provider of note. The longer you can delay your withdrawals, the better rate of return you will be entitled to. At age 65 you will currently receive a guaranteed 5% (after fees and tax) per annum, with an increase of 0.1% per year your first withdrawal is delayed. If you can delay until age 70, your returns will be 5.5% per annum. The protected income rate can change at any time, but once you have been given one it cannot fall. It can only increase if the value of your investment returns increased.
Investment returns are only one feature of returns because the lifetime withdrawal benefit is protected by insurance. This means you will receive the lifetime withdrawal benefit regardless of how the fund has performed. Your money is guaranteed even if your balance runs out, due to the backing of a lifetime group insurance policy. The returns of the fund are only important if you die of if the fund is wound up. The risks here are that your estate will end up with nothing if your investment returns were poor and inflation.
Let’s say inflation is 3% per annum and you have $500,000 in your annuity, receiving a 5% return. Your annual payment will be $25,000. Not too bad. The problem with inflation though, is in 20 years our $25,000 payment will only be worth $14,000. Almost half of our initial withdrawals, assuming the fund doesn’t increase in value. If you are withdrawing 5% value per year, the chances of your fund increasing in value is quite low and may require taking on more risk than you are comfortable with. A lower withdrawal rate would be much less susceptible to inflation risk, but with annuities it is not you that dictates the withdrawal rate. It is the provider.
The fund has two portfolios: the balanced and cash. Your investment will predominantly be in the balanced portfolio consisting of low cost index funds with underlying exposure to shares and fixed interest securities in New Zealand and internationally. The cash portfolio will only make up a small portion to balance out the higher risk of the balanced portfolio. So that the annuity provider can maintain its commitment to you and your investment expenses.
The minimum investment size is $25,000. The minimum investment age is 60, and the maximum 90 years old. Any money left over upon death will be transferred to your partner for the rest of their life. If both partners pass away, the remaining account balance will go to your estate. Unlike a traditional annuity, you can withdraw your capital at any stage.
4/. Reverse mortgage
This is a pretty controversial option according to popular opinion. With New Zealand’s obsession with owning property, a lot of near retirees end up cash poor, but with a lot of money tied up into the house. Reverse mortgages allow people that own their homes aged 60 and older to release capital from their homes for spending.
You simply apply for a loan of how much you need. The loan is usually paid back on sale of the property or on death. Make sure that your spouse is also named on the loan, or the bank may force the surviving spouse to pay off the loan upon your death. Note that your spouse will also need to be over the age of 60 to be eligible for the reverse mortgage loan. The bank lends based on the age of the youngest borrower. The banks will generally only lend between 15% and 50% of the value of the property depending on how much is remaining on the mortgage and how old you are.
The reason reverse mortgages get a bad wrap are because of high repayment rates and children of the retirees feel like their parents are eating into their inheritance. My opinion is it is not the children’s’ money in the first place and you just need to do what is right for you. A more reasonable criticism of reverse mortgages are the high fees. The interest rate for repayments are typically 1.5% - 2% higher than the market variable rate. Because repayments are not made until the end of the loan, then this can really blow out. There is no requirement to repay the loan whilst living in the house.
Let’s take an example of a $900,000 property that is fully paid for. The bank has allowed us to borrow 15% or $135,000. The interest rate charged by the bank was 8.5% and the loan period 10 years. Set up costs of $2,000. Over the 10 years, our initial $135,000 loan has cost us an extra $172,233 in interest and fees.
When borrowing against the house we must also be aware that if the value of the house goes down then that will leave us with even less equity. If you must borrow some money against the house, at least consider the possibility of a decrease in house prices, so that you do not leave too tight a margin. Conversely, rising property prices can help offset the interest costs.
5/. Other hedges against sequence risk
You can look to save more than you need. This may mean working another year or two before retiring.
You can work part-time during your first few retirement years to boost your income.
If you own a home, you can rent out a room to help with expenses.
You can downsize your house to free up some cash.
Staying healthy. Not only will you be more likely to earn some income but you will also save on healthcare costs.
In periods of poor economic growth, you can tighten your expenses. I recommend spending a percentage of your portfolio. If your portfolio goes down, you will spend less. If your portfolio goes up you can spend more.
Final Thoughts
The catch 22 situation is that sequence risk only occurs with high risk investments such as stocks, yet most of us need at least some of our investments in high risk because our retirement portfolios are not large enough to last on paltry returns. Do not rely on NZ Super being enough. Even if NZ Super is still active when you retire, it won’t raise faster than the cost of living, that is for sure.
I have provided plenty of options that can help to reduce your exposure to sequence risks if you are concerned about outliving your money. You do not have to choose one or the other either. You can go with any combination of options you like. Diversification is an effective tool against sequence risk.
Earning income in our retirement years can be difficult, so it is imperative we plan as best we can because it is a terrifying thought to run out of money and not be able to do anything about it.
If you are heavily invested in the stock market, a good indicator of if we may be close to a downturn is by looking at the price/earnings (PE) ratio. The average of the last 20 years has been 15. We are currently sitting at 20. No one can predict the future with certainty, however I would be expecting a market downturn in the next 3 years. It is a very high P/E by historical standards. If I were retiring now, that is how I would be planning anyway. Experiencing prolonged recessionary environments early in retirement is a large determinant of whether your money will last or not.
Your spending should be based on a percentage of your balance. Not a fixed amount. My personal preference is 3.5% consistently. Alternatively, 4% in good years, 3.5% in average years and 3% in bad years. By using a percentage, we are spending less in bad years and more in good years. We shouldn’t expect to have a constant spending pattern in a volatile portfolio. Those who want a bit of risk and the potential upside, should be flexible with their spending and make adjustments. Investing too much in stocks and withdrawing too much in the first ten years of retirement will largely dictate whether you outlive your money.
If you need help with your personal retirement planning, then get in touch today.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here
Share your thoughts below. What are some ways you have stretched your money to last longer? Do you have concerns of not having enough money? How have you been struck by good or bad luck with your timing?