The “glide path” in accumulation applies only when you’re saving money, not when you’re making withdrawals. Here’s an important decumulation angle.
A couple of recent conversations reminded me that, although I’ve written about the investment glide path in the accumulation stage (Posts #78 https://donezra.com/78-glide-from-youth-into-life-two-walk-20/ and #81 https://donezra.com/81-target-date-funds-and-how-to-improve-them/) – the sensible path being a decline in equity exposure as you approach retirement – I haven’t said anything about the corresponding glide path in the decumulation stage; and it’s clear (I hope) that the glide path that’s appropriate when you’re putting money in isn’t necessarily going to be equally appropriate to continue when you’re taking money out.
It’s true that I have written once (Post #33 https://donezra.com/33-decumulate-four-ways-to-generate-sustainable-income/) about decumulation, explaining the four approaches that can be applied consistently, involving a choice between (or of course some combination of) an invested pension pot, and some form of deferred or immediate annuity. But that post focused on creating a consistent overall process, rather than on how you might invest the non-annuitized portion of your pension pot.
In fact there isn’t any decumulation approach that has been widely accepted. There are approaches that suggest an increasing equity exposure as you age, others that keep the exposure constant, and yet others that suggest a declining equity exposure. This is, as you can therefore guess, a difficult and contentious subject.
In the soon-to-be-uploaded book Freedom, Time, Happiness I’ll include a couple of pieces on the subject, one explaining the bases cited by experts for each of the increasing, constant and declining glide paths in decumulation, and the other a case study on how one particular couple thought about their goals and how their attitudes might change as they aged.
Meanwhile, in this post I’ll explain, as simply as I can, a particular financial risk that can arise in decumulation, commonly called “sequence-of-returns risk.”
Yes, I’m going to over-simplify. But the over-simplified example will still make the point clearly. Bear with me while I construct a very artificial example, because I’ll draw some useful conclusions from it.
Suppose (in this over-simplified example) you have $1,000 and want to withdraw $100 at the end of each of 10 years. Let’s assume you earn a 0% investment return each year. Then obviously you’ll be able to withdraw your desired $100 a year for the 10 years.
OK, now the first of two variations.
Suppose you invest the money and earn 20% in the first year, 0% in years 2 through 9, and -20% (that is, you lose 20%) in the 10th year. Focusing only on the returns, your average return over the period is still 0%. But look what happens to your withdrawals.
At the end of the first year your initial $1,000 has increased to $1,200 because of your 20% return. If you withdraw $100 a year for the first 9 years, you’ll still have $300 left at the start of the 10th year. Because of the -20% return in the 10th year, that $300 will be reduced to $240 at the end of the 10th year, and that’s what you’ll be able to withdraw – much more than the $100 you wanted.
OK, now the second of the two variations. This time let’s suppose you earn -20% in the first year, 0% in years 2 though 9, and 20% in the 10th year. Again, focusing only on the returns, your average return over the period is again 0%. But again, let’s see what happens to your withdrawals.
At the end of the first year your initial $1,000 has decreased to $800. So you can’t withdraw $100 a year for 10 years! It doesn’t matter that you’ll prospectively earn 20% on your start-of-year-10 balance, because there isn’t a balance.
You can probably see where this is headed.
If all you focus on is returns, the base case and the two variations all come out with the same average 0% return. But the amounts of money on which those returns are earned are different, in the three cases.
In the second case the high return is earned on a large amount of money and the low return on a small amount of money. That leaves money to spare, at the end.
In the third case the low return is earned on a large amount of money and the high return on a small amount (in fact, on no money left at all). That exhausts the money before the end of the 10-year time horizon.
So, even though a focus on the average return fails to distinguish between the three cases, in practice the sequence of returns is important, because the amounts of money at various times are different.
In fact, to generalize from this simple case, here’s what happens. If you earn low or negative returns early in decumulation and high returns later on, that’s bad news. Earning high returns early and low returns later is much more favorable.
Earning lower-than-average returns early is called sequence-of-returns risk.
And so, here’s the lesson. Even though financial professionals may assume some average return over your decumulation time horizon, it’s potentially dangerous if that’s all they do. Because of sequence-of-returns risk, they should also explicitly create a way to insulate you from, or mitigate the effects of, that risk.
One possible way is to have a few years of spending held in short-term deposits that aren’t subject to market volatility. Another is to have a lower equity exposure in the early years than in later years. And there are others. All are aimed at reducing the impact of sequence-of-returns risk. And all therefore reduce the pot’s overall growth potential, since safety and growth are at opposite ends of the risk spectrum. So there’s no perfect solution.
As you will have guessed, my point today is not to suggest there’s a perfect solution. It’s to explain this particular decumulation risk.
You may not have been aware of it. Perhaps your professional didn’t discuss it with you. Perhaps you do your own thing, and never thought about it.
Perhaps you think (or your professional thinks) that your life expectancy gives you a potentially long investment horizon at the start of your Life Two and you can therefore ride out early negative investment fluctuations. But in fact in decumulation you potentially have multiple time horizons. Each withdrawal has a horizon equal to the time when you want to make that withdrawal. For example, if you want to make a withdrawal at the end of the first year, that amount has a horizon of one year – not typically consistent with the risk of equity exposure. It’s only subsequent withdrawals that have longer horizons.
Of course, if your pot puts you in the “endowed zone” (see Post #51 https://donezra.com/51-wealth-zones-essentials-lifestyle-bequest-endowed/), then you do indeed have a long (theoretically infinite) investment horizon because you never have to sell any part of your pot to finance your lifestyle. But in any of the other wealth zones, sequence-of-returns risk is something you should consider, whether you do your own investing or you rely on a financial professional.
In decumulation, an invested pension pot carries risks. One is sequence-of-returns risk. Regardless of the average long-term investment return, it’s bad news, in decumulation, if low or negative returns occur early.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.