Money on the Table for Retirement
by Craig L. Israelsen, Ph.D.
It happens to everybody. After spending your working years accumulating money, you face a rude awakening in retirement when that growth is replaced by withdrawal. This drawdown phase might be described as the relentless cracking of the retirement nest egg.
Analyzing how asset allocation affects portfolio durability during retirement is a big issue. But there is no perfect retirement portfolio. Every investment faces some type of risk, including equity volatility risk, interest rate risk, inflation risk and currency risk. The key is to build a portfolio that addresses each unique risk while maintaining adequate exposure to needed portfolio growth, especially during the drawdown or withdrawal phase of retirement. Diversification across asset classes is one such way. Living on your nest egg and allowing it to endure through thick and thin should be of paramount importance to every retiree.
Ponder this: are average diversified returns good enough? Should diversification be a lifelong strategy, both before and after retirement? Yes, most definitely. According to my research, the virtue of multi-asset "average" performance only becomes fully apparent over time. The challenge of building a multi-asset portfolio is in the short-run, not the long-run. Said differently, a multi-asset portfolio will never outperform the best performing individual asset class in any given year, but in the long run, (historically speaking) it will win the portfolio return race with reduced risk. Multi-asset portfolios are steady, not flashy. Therein lies the problem: the best performing asset class of last year may create investor "envy" which can lead to "performance chasing" -- which consists of reallocating all or a portion of their portfolio to last year's winning asset class or strategy. Such an approach is nonsense -- but so are a lot of things we humans do.
What about the attainable withdrawal rate and your account depletion rate over time, relative to your risk and return? This question refers to the general issue of retirement portfolio durability.
In my recent research studies, I have found confirmation that the performance of a broadly diversified portfolio during retirement is a superior strategy than investing in less diversified portfolios.
For example, a diversified 4 asset class portfolio (large US stock, small US stock, bonds, and cash) with an annual withdrawal rate of 4% clearly outperformed a 100% bond portfolio or an age-weighted bond/equity portfolio. From 1926 thru 2014, using 35 year rolling periods, it was found that a 4 asset class diversified portfolio achieved success 98% of the time and finished with the highest average balance. And even with a 5% annual withdrawal rate, the success rate was 89% for the 4 asset portfolio during the same time period, and the average ending balance after 35 years was dramatically larger than the narrowly invested portfolios employing 100% bonds or an age weighted stock/bond portfolio.
Mark Wendell of MD Wendell Wealth Partners in Westlake Village CA, expressed his views on this subject: "Using diversifying techniques helps investors protect themselves from themselves--that is, employing diversification strategies will counter investors' tendency to make the human behavioral error of focusing on the most recent performance or winner, rather than correctly and most importantly, focusing on attempting to achieve a smoother ride with superior longer-term results, especially in view of their monthly withdrawals. Using a more volatile risk-oriented strategy while withdrawing funds, clients may end up with a negative dollar cost averaging effect or a negative compounding result due to losses on some monthly payouts combined with distributions of interest and dividends. the result of this approach usually is lower long-term returns and quicker account depletion. Most people do not realize this negative impact on volatile portfolios while withdrawing funds, nor do they realize the difference between common sense investment risk and gambling hope, which is why I put so much emphasis on portfolio risk-managed returns for my clients' portfolios rather than stretching risk for higher total returns."
Craig L. Israelsen, Ph.D. is an Executive-in-Residence in the Financial Planning Program at Utah Valley University. He is an author, speaker, professor and also the developer of the 7Twelve Portfolio (www.7TwelvePortfolio.com).