By Keith Whitcomb
The COVID-19 pandemic is the latest crisis to prompt panic-driven investor selling during a market downturn. In February, Morningstar reported large withdrawals out of long-term investments. However, at this point, it looks like the “professionals” ran for the exits. According to Vanguard, retail investors, in particular those in defined contribution plans like 401(k)s, have been "maintaining a long-term perspective despite the market turmoil."
This is good news given individual investors have a long history of bailing out when the market drops. And for people accumulating assets who are decades from retirement, a “set it and forget it” strategy in a target-date fund can make a lot of sense. But, if you are in retirement, you may be forced to sell investments because you need money to pay your bills. And those nearing retirement now face a classic “sequence of return” risk that occurs when a market downdraft hits just when you need to start making withdrawals from your portfolio.
So, are you stuck with “selling low” in a down market or is there an alternative?
Floods and Hurricanes
If the current pandemic has taught us anything, it is that market performance is unpredictable and predictable. What does that mean? While it is unknown exactly when markets will go up and down, there is an understanding that they will continue to do so. Market volatility is not like a one-off disaster that just occurs out of nowhere, e.g., meteor dropping on your house. It is more like dealing with adverse weather conditions when you live on the shoreline of an ocean. The question isn’t “if” but rather “when” the next tropical storm will arrive. The good news is that there are ways to mitigate or even eliminate this homeowner's risk.
- Avoid living in an area that is exposed to such perils
- Design a house to minimize damage from high winds and flooding
- Insure to protect against natural disasters
Similar to real estate, investors have access to thematically similar financial products that dampen or eliminate retirement income risks.
Beyond Investment Portfolios
Research at the Brookings Institution takes a logical step forward from the classic retirement asset allocation approach of 60% stocks and 40% bonds by partitioning financial resources into the following three buckets:
- Emergency fund – Avoid market exposure with liquid investments like FDIC-covered bank accounts
- Managed payout fund – These funds are designed to produce stable income payouts, although not guaranteed
- Qualifying longevity annuity contract (QLAC) – This product guarantees income later in life to insure against market and longevity risks
This reflects similar retirement income research around the world, e.g., United Kingdom, Australia, Canada, and others. It focuses attention on the nature of income generation instead of merely investments in a portfolio. Asset allocation essentially becomes a subset of a financial management approach designed to generate and secure income over a lifetime. The problem at present is that uptake of managed payout funds, where as much as 90% of assets are suggested to be located, has been characterized as “minuscule.” Why is that?
The Joseph Strategy
Perhaps at some point in your life, you learned about the biblical story of Joseph. You know, the one that ended up on Broadway in “Joseph and the Amazing Technicolor Dreamcoat.”
Joseph was famous for his interpretation of Pharaoh’s dreams of cows and grain. He predicted that Egypt would experience seven years of plenty followed by seven years of famine. Joseph proposed a plan that called for a 20% savings rate during the good years to manage crop yield volatility while still providing for ongoing consumption.
Using a systematic approach like this to eliminate emotionally impaired judgments is advocated by modern-day behavioral finance which, according to Investopedia, “proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners.” To avoid irrational and potentially destructive decision making, the Corporate Finance Institute (CFI) advises to “Focus on the Process,” and “Prepare, Plan, and Pre-Commit.”
The point here is that Joseph had a 14-year plan to deal with a resource crisis instead of just hanging onto platitudes like “diversify to reduce risk” and “stay the course.”
The Process of Planning
President Eisenhower once said, “plans are worthless but planning is everything.” While this quote may be interpreted in a number of ways, it highlights the value of an ongoing planning process as opposed to a static view of a plan. Actively monitoring and revisiting retirement cash flow assumptions on a regular basis may actually align with behavioral finance goals that seek to avoid reactive decision making. This could engage people in a way that the “one-size-fits-all” managed payout fund apparently hasn’t.
An alternative could use a process that continuously reviews and matches liabilities with laddered CDs or defined maturity bond ETFs. This would support a long-term rational investment approach that would be responsive to life events and help you avoid “selling low.”
Measuring Success: Dollar-Weighted Returns
During the accumulation years, you want to understand manager and/or investment performance. Using a time-weighted rate of return is perfect for this analysis given it ignores cash flows. This makes sense because a manager/fund has no control over deposits and withdrawals and therefore should not be judged on results that are influenced by them.
In contrast, during retirement, you need to evaluate how well your investments are performing as a result of ongoing withdrawals from the portfolio. Cash flow is not random, or unexpected. The portfolio strategy now needs to account for known cash flows, not disregard them. To do this, evaluate performance by using a dollar-weighted rate of return. This will highlight the impact of cash flow and the sequence of returns on overall performance. Here is an example that uses assumptions from a study produced by the Insured Retirement Institute in their 2019 Fact Book.
The “lucky” investor receives 17% in year one, 10% in year two, and -8% in year three. This sequence repeats itself over 21 years. Meanwhile, an “unlucky” investor receives the same returns in the same pattern but in reverse: -8% then 10% then 17%.
Both investors draw down equal payments of $19,800 each year and start with approximately $250,000. While time-weighted results are the same, a dollar-weighted calculation shows the impact of return volatility and cash flow on the portfolio. As this evaluation shows, a time-weighted rate of return isn’t an appropriate measure of success given generating cash over time is now what you care about.
While it is difficult to avoid market volatility, what you can do is create a framework that allows you to move through different investment performance environments with a level of control that fits your circumstances. The value is in the management of the situation, not that you never encounter investment challenges. It is about helping you remain focused on cash generation while avoiding damage in a down market that could result in a portfolio “death spiral” where investment gains have no chance of out-growing withdrawals. Changing to a mindset of budgeting and throttling cash flow while moving away from purely measuring manager/investment performance is the key.
About the author: Keith Whitcomb MBA, RMA®, is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.