You need to add significantly more risk to your investment portfolio in order to pursue the same rates of return as 10 years ago, according to a report from Callan Associates, one of the largest pension consulting firms in the world.
A portfolio with a high standard deviation (a historical measure of the variability of returns relative to the average annual return) has experienced volatile returns, while a low standard deviation indicates returns have been less volatile. According to Callan’s data, a pension fund targeted to achieve a 7.5% return in 2005 could have more than 50% of the portfolio in bonds, reducing the risk and resulting in a standard deviation of 8.9%. To pursue the same 7.5% rate of return today, the pension fund needs to have a much smaller percentage in bonds (12%) with the balance in equities, raising the standard deviation to 17.2%.
How can this data on pensions be applied to an individual retiree?
To re-create this scenario, my firm used a Monte Carlo simulation, a risk and decision analysis technique that evaluates the outcome of portfolios over time using a large number of simulated variables to generate possible future returns. This mathematical process considers variables such as initial portfolio value, withdrawal rate, inflation, expected return and the standard deviation, among other variables, which may affect the portfolio outcome. It is used to imitate real-life situations and, in order to produce meaningful results, these simulations are processed many times. By varying the rates of return and inflation to simulate the fluctuations that can be experienced in the marketplace, the simulation seeks to present a more realistic reflection of the anticipated ups and downs of the investment environment.
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In utilizing this analysis tool, I found that the chance of running out of money during retirement today is more than 10 times greater than it was 10 years ago. For the scenario of the individual retiree in 2005, we used a 7.5% expected rate of return, 5% withdrawal rate and adjusted for 3% inflation. The result was a 2.4% fail rate. This means only one in 40 people would have run out of money during a normal retirement beginning in 2005. To apply this to someone starting to withdraw today, we ran a simulation with the same withdrawal rate and inflation factors as before but, this time, the result was a fail rate of almost 25%.
For an investor more than five years away from retirement who is continuing to invest each year, market volatility will not have as large of an impact. The longer the time horizon, the greater the potential to grow the portfolio. However, for an investor fewer than five years away from retirement or currently retired, negative volatility in the market increases the chance of running out of money.
What does this mean for you?
So, you may ask, should you lower your expectations for returns in order to reduce risk? Or accept that you need to take on more risk in order to go for higher returns? The answer is dependent on what failure looks like to you. If you have sufficient income to cover your needs (such as from a pension, Social Security or high-quality predicable income, i.e. high-quality bonds), then you may have the ability to take greater risk. For example, if you designate the fixed income-oriented portion of your portfolio to cover needs and designate the growth component of the portfolio to cover wants, when there is a market downturn you may need to sacrifice discretionary items but hopefully not basic daily living needs.
In addition, have a game plan should there be an extended correction in the market. For example, if there was an extended correction, would you be willing to work temporarily to earn enough to cover the shortfall? Maybe in an area of interest, such as a part-time position at a garden canter. If you have equity in your home, would you could consider downsizing? Would you access the value of your home, either by a home equity line of credit to cover a short-term deficit or by considering a reverse mortgage as a longer-term solution? It is important to consider your options now so you will know what to do if you need to offset a shortfall in the future.
Surprisingly, most financial software uses historical rates of return that create assumptions for fixed income that are almost mathematically impossible to achieve in the current interest rate environment. These assumptions can lull consumers into a false sense of security.
It is important to note that due to the random nature in which the Monte Carlo simulations are generated and the regular updating of historical asset class data, the results may vary with each use and over time, even if the underlying assumptions are not changed. However, the takeaway from these surprising results is that during the wealth-accumulation stage, time and volatility can be your friend, but during distribution, they are often your enemy. It’s not just about your returns. It’s also about the risks that you are accepting for those returns. Talk to your financial adviser about risk tolerance to find a balance that is right for your personal situation.
Mark Cortazzo, CFP®, CIMA® is the founder and Senior Partner of MACRO Consulting Group, an independent wealth management firm located in New Jersey.
IMPORTANT: The projections or other information generated by Monte Carlo Simulations regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
The analysis does not utilize historical data for any specific securities.
Securities offered through LPL Financial, member FINRA, SIPC. Investment advice offered through MACRO Consulting Group, LLC, a registered investment adviser and separate entity from LPL Financial.
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