Investing in Retirement

It is daunting when we think about how hard it is to save enough money to feel that our retirement will be a comfortable one. Savings such a large amount is hard.  Making sure you don’t run out of money in retirement and living life to its fullest is an even harder one.  Nobel laureate William Sharpe in fact described the process of with drawing from your savings (often called decumulation) as the nastiest and trickiest problem in finance.

This is problem so complex, because it has 2 distinct and completely random and unrelated components which when taken together are unique for every individual. Here we will focus on the first part, the sequence of returns.

Sequence of Returns

Consider that your savings are to be invested and spent from the day you retire until you die at the age of 100. There are effectively 3 paths your journey can take.  Path one (the black line one the graph) has a 7% compounded growth rate. Although 7% is the long term average often quoted around an investment in the major indices, we know that the straight line 7% does not exist, investment just don’t behave this way. 

Now consider a second path (shown in blue), perhaps retirement started in 2012. This path has strong investment performance very on in the retirement journey, but still averages 7% and ends up at the same place as path one.

Finally path three (in red) started with retirement in 2007. Early returns were poor and there were losses in 2008. Year on year returns recover and over the same period still maintain a long term average of 7%.

All 3 paths have the same rate of return.

Were both of these investors still in their accumulations phases, and continuing to save and invest along the way, the order in which returns came would not matter.  Each investor would find themselves with the same amount of money. When you are drawing down on your savings though, the sequence of returns matters and we can in fact afford to take less risk early in our retirements than we can in the latter years. If you make money (particularly in excess of the average) it helps you a great deal.  Losses early on however are highly punative.

What happens to the money of each investor?

Assume each investor started off with $1,000,000.

The blue investor saw their money grow early on and in fact by the time they pass at age 100 has an estate with value greater then they started with.

The red investor who saw early losses was never able to recover. The red investor (like the blue investor) had to keep spending to fund retirement actually ends up running out of money before reaching the end of their retirement journey.

The difference between the to investor journey’s highlights that it is not just the numerical rate of return you earn that matters, but when you experience the different degrees of returns. that matters.

The dollar cost averaging that worked so well in accumulation turns on its head when you start drawing down

Protecting yourself

Protecting yourself is analogous to going out walking and being faced with “the wind chill factor”. The ambient temperature may not be that cold but with the wind picks up you cool down very quickly. The best way to protect yourself is to cover yourself with something like Gore-tex. When you build your investment strategy for your drawdown year it is important to consider a balance that may be slightly skewed to downside protection over long-term grown.

Your investment strategy should be just like your investment in Gore-tex.

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