The reality of distributions in a down market

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Mar 9, 2008 10:45 am

I recently attended a presentation (sponsored by an annuity company) about the fallacies of traditional investment planning during distribution. Here were the key points of discussion:

 
1-Systematic liquidation during a down market (think about it, taking a 5-6% withdrawal and portforlio is down 15%). Wouldn't take many years to deplete would it? And since we are living longer the possibility of experiencing several down markets during a retirement is likely.
 
2-Timing of withdrawals. What if you started taking distributions and the market was flat or down for a decade. It happened in the 70's. I was suprised to read that 32% of the years since the market began, the market was up 20% or more annually,  and 20% of the time the market was down 15-20% annually. Only in 2 years since 1900 did the market average 10% annually (which is the average for the market) and NEVER did it average 8-9% annually.
 
3- Time value of fluctuation. Most of us understand the time value of money but what about the time value of fluctuation? If you were an engineer perhaps you might take the time to calculate market performance from the beginning of the market and run it out each year to see how it performed and whether or not you met the goal of having enough to retire on.
 
Jim Otar, an engineer, who is a CFP and a whole bunch of other letters after his name did. And he developed his own excel based software program (it's not pretty but it is amazing)
its cheap but it is worth checking out. He has trial version on his website.
 
A  couple of other stats that were eye openers. Withdrawal rates at age 65 should start at 3.6% (indexed for inflation) not 5-6% (when I started in the biz in 94 we were using 8%!). 4 year look back theory; IF the portfolio was less at age 69 (assuming retiring at age 65) according to Otar's calculations, there was a 95% probability that retiree would run out of money, regardless of market perfomance.
 
So Spiffy whether we use A shares or fee based planning in accumualtion phase is irrelevant. What matters most is how much we distribute and when. At this presentation I was sitting with several CFP's and many industry vets. All of us were amazed and concerned that maybe our best laid plans for clients might fail. MPT and asset allocation models we have been taught for accumulation don't transfer to distribution. And with the majority of our clients moving towards distribution our focus had to be to shift that risk and NOT rely on the market to save us.
 
Why do I bring this thread up? Because most if not all of us have never been fully trained on the perils of distribution.  Most of us have not been through a protracted down market either. I remember the 70's ( I was a teen) but I wasn't investing then, and I wasn't an adviser to those that needed income from their investments. If any of you have that history it would be good to hear your experience.
 
Mar 9, 2008 12:15 pm

Ice-

 
Are you suggesting that colleges today are teaching our kids that the theories we were brought up to believe are faulty? Why haven't we heard more. Nothing in registered rep mag or other financial publications over the last 15 years since I started ever represented that accumulation strategies would be doomed in distribution phase.
 
What a paradox if your assertions are true. I would be suprised if colleges today aren't teaching MPT and asset allocation. Can you be more specific how or what they are teaching for distribution strategies.
Mar 9, 2008 1:58 pm

Ice-

 
If 5% withdrawals are a bad idea, why would actuaries (supposedly fairly intelligent people ) allow for 5% withdrawals at 60?
 
Incidentally, I pulled Otar aside afterwards and posed this question to him and he smiled and said that he thought according to his thesis it was better for carriers to accept the risk than us?
His website is http://www.retirementoptimizer.com
 
It would be very interesting if you could identify in general your creative planning strategies for distributions.
Mar 9, 2008 2:13 pm

Ice-

 
Sounds to me that your distribution plans might include annuities. Am I anywhere close to reality?
 
Or do you have non-human investment concepts! I am not trying to be saracstic, just interested in other strategies (if there are any that include guarantees for one not to outlive their income).
Mar 9, 2008 2:34 pm
footsoldier:

I recently attended a presentation (sponsored by an annuity company) about the fallacies of traditional investment planning during distribution. Here were the key points of discussion:

 
1-Systematic liquidation during a down market (think about it, taking a 5-6% withdrawal and portforlio is down 15%). Wouldn't take many years to deplete would it? And since we are living longer the possibility of experiencing several down markets during a retirement is likely.
 

 
This is usually referred to as the "sequence of returns" risk. American Funds has some literature on this, but I "think" T. Rowe Price first introduced the concept. And, as you explained, it describes the problem with taking withdrawals during market declines.
 
One possible solution might be "asset dedication" (AD), which is when you take a portion of the client's assets and dedicate them to providing a reliable source of income for 5 or 10 years. The remaining portion of the assets are allowed to be invested undisturbed; thereby, allowing time to (hopefully) overcome market declines. As we all know, the longer you're invested, the better your chance of experiencing a positive return.
 
An (AD) portfolio might be structured like the following:
 
Determine beginning annual income needs: $30,000 plus inflation. Buy bonds with (1-4) year maturities or buy any other reliable source of income for years (2-5).
 
1) Put $30,000 of assets in MMF for first year's income needs.
2) $31,500 required 2nd yr's income: Comes from (bond interest + mat. prin. of 1 yr bonds).
3) $33,000 required 3rd yr's income: Comes from (bond interest + mat. prin. of 2 yr bonds).
4) $34,500 required 4th yr's income: Comes from (bond interest + mat. prin. of 3 yr bonds).
5) $36,000 required 5th yr's income: Comes from (bond interest + mat. prin. of 4 yr bonds).
 
And of course, what hasn't been invested in bonds to supply income during years (1-5), was invested in equities undisturbed. Then, after year 5, you redo the whole process: take a portion of your remaining equity assets, buy bonds and leave the rest in equities to (hopefully) grow undisturbed.
 
Of course, you can do this type of investing for any period of time, 5 yrs, 10 yrs, etc.
 
This process eliminates the "sequence of returns" risk, since the client isn't drawing from an ever decreasing pool of funds. Plus, the client, knowing that they have a reliable source of income for a fixed period of time, are more likely to ride-out any market volatility.  
 
A good book was written on the subject: "Asset Dedication" by Stephen Huxley & J. Brent Burns. Last time I checked, you can only get it at Barnes & Nobles: www.bn.com .
 
Good luck!
 
 
Mar 9, 2008 8:14 pm

Asset dedication is a good as are fixed and variable annuities, and so are SWP's & having the appropriate LTC insurance in place to mitigate the risk of a large withdrawal.



One of the things such intellectual discussions often leave out is that each individual client will have their own perspective on what will work for them & what they want to do. Some clients refuse to buy a VA or a FIA because they fear loss of control of their assets. Some clients will only want to work with one fund family even though families & styles of management run hot and cold.



It's our job to lead them to a strategy that we believe will give them income they can't outlive, satisfy their bequest motives, stay within their risk tolerance(which they may or may not be able to accurately communicate to us) & provide them flexibility to change along the way. Then to maintain the strategy and the relationship through various markets & life transitions.



There is no one right way. I think iceco1d's 3.5% withdrawal rate is too conservative, but if ice believes we're heading for early 1970's returns & inflation - he's right on & perhaps too aggressive. He'll attract clients who buy into his philosophy.



My questions are: Baby boomers have NEVER planned for more than the 6 - 12 months. How are you getting people to talk about and plan for 25 - 30 years? They also tend not to believe they are average & so how do you help them buy into the studies that we see regularly: The average 65 yr old person's healthcare cost will be $230K + over their lifetime (nearly $500K for a married couple). That if one is expecting to live on SS(and the average is about $1000 pp) that medicare costs are something in the range of $500 per month just for part A & B? That they will likely spend MORE money in the first several years of retirement than they do in their working lives? Etc.

Mar 10, 2008 7:48 am
 
[/quote]
 
This is usually referred to as the "sequence of returns" risk. American Funds has some literature on this, but I "think" T. Rowe Price first introduced the concept. And, as you explained, it describes the problem with taking withdrawals during market declines.
 
One possible solution might be "asset dedication" (AD), which is when you take a portion of the client's assets and dedicate them to providing a reliable source of income for 5 or 10 years. The remaining portion of the assets are allowed to be invested undisturbed; thereby, allowing time to (hopefully) overcome market declines. As we all know, the longer you're invested, the better your chance of experiencing a positive return.
 
An (AD) portfolio might be structured like the following:
 
Determine beginning annual income needs: $30,000 plus inflation. Buy bonds with (1-4) year maturities or buy any other reliable source of income for years (2-5).
 
1) Put $30,000 of assets in MMF for first year's income needs.
2) $31,500 required 2nd yr's income: Comes from (bond interest + mat. prin. of 1 yr bonds).
3) $33,000 required 3rd yr's income: Comes from (bond interest + mat. prin. of 2 yr bonds).
4) $34,500 required 4th yr's income: Comes from (bond interest + mat. prin. of 3 yr bonds).
5) $36,000 required 5th yr's income: Comes from (bond interest + mat. prin. of 4 yr bonds).
 
And of course, what hasn't been invested in bonds to supply income during years (1-5), was invested in equities undisturbed. Then, after year 5, you redo the whole process: take a portion of your remaining equity assets, buy bonds and leave the rest in equities to (hopefully) grow undisturbed.
 
Of course, you can do this type of investing for any period of time, 5 yrs, 10 yrs, etc.
 
This process eliminates the "sequence of returns" risk, since the client isn't drawing from an ever decreasing pool of funds. Plus, the client, knowing that they have a reliable source of income for a fixed period of time, are more likely to ride-out any market volatility.  
 
A good book was written on the subject: "Asset Dedication" by Stephen Huxley & J. Brent Burns. Last time I checked, you can only get it at Barnes & Nobles: www.bn.com .
 
Good luck!
 
 [/quote]
 
Dob-
 
I must be missing something. Do I understand this correctly, that for every year past year one part of the income mix is the principal of matured bonds? If the clients are using this principal aren't they drawing down their pool of assets? What am I not getting here? Additionally, isn't year one's funding of the MMF for income also drawing down their pool of assests?
 
Mar 10, 2008 7:44 pm
BondGuy:
 
Dob-
 
I must be missing something. Do I understand this correctly, that for every year past year one part of the income mix is the principal of matured bonds?
 
Yes. Year 1's income comes from cash in a MMF. Year 2's income comes from the maturing principal of the first set of bonds and interest from the other bonds. Year 3's income comes from the maturing principal of the second set of bonds and interest from the other bonds. Year 4's income...
 
If the clients are using this principal aren't they drawing down their pool of assets?
 
Yes short-term, but in order to keep their equity investment undisturbed.
 
What am I not getting here? Additionally, isn't year one's funding of the MMF for income also drawing down their pool of assests?
 
Yes, short-term it is. 
 
 
Various performance charts are presented in the book, which compare (AD) to various allocations to stocks/bonds; i.e., 70/30, 60/40, etc. The charts measure performance in rolling decades, from (1926-2003). The closest competitor to (AD), in terms of performance is the stock/bond allocation of 70/30. Average annual return for (AD) 8.70% vs 70/30 at 8.60%. Out of 69 rolling decades, (AD) won 34 vs 23 for the 70/30 allocation.
 
Some of the performance numbers are more impressive for the more recent time span of (1976-2003), with (AD) averaging 12.60% per year & 70/30 averaging 12.40%. Granted, not earth shattering, but (AD) won 14 of 19 rolling decades.
 
This might be a good client management tool, especially in this market. Plus, you can mix 'n' match with the formula. For example, if your client isn't retired and/or taking income, you could buy enough zero's to mature (when they do take income) and invest the rest in equities.
 
Buy the book and see what you think. As for me, I like the concept. Another arrow in my quiver...
Mar 11, 2008 8:43 am

Interesting! Thanks Dob

Mar 11, 2008 9:15 am

Dob, that's a very sound strategy.  I've been doing a variant of it for some time as I always have a year's worth of draws sitting in cash and often a bond ladder or funds, depending on the situation to go along with it.  Well said.

Mar 11, 2008 10:23 am

This "Asset Dedication" sounds an awful lot like an academics slant on the "Buckets of Money" approach long espoused by Ray Lucia on his nationally broadcast radio show. 

The part that intrigues me is the potential to help modify clients' behavior by giving them a 'buffer' period where they don't have to worry quite so much about short term volatility since they have their short term 'safe' money. 

I could be mistaken as I haven't spent a lot of time reading up on either one, but maybe one of you are more familiar and can comment on the apparent similarities.

Mar 11, 2008 2:21 pm

The "sequence of returns" concerns helps me to get my clients to understand the importance of having an investment that is guaranteed to grow in value every year.  Once they understand that, a whole life insurance sale often follows for that part of their portfolio.