Recovery rates and the effect of volatility on retirement success


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Recovery rates and the effect of volatility on retirement success

  1. 1. Whitepaper Recovery Rates and the Effect of Market Volatility on Retirement Success James L. Wiley Edgar W. Lambert Alexander F. Cabot, ChFC®
  2. 2. Recovery Rates and the Effect of Market Volatility on Retirement SuccessMarket volatility over the past few years has been a constant headline. The goal of this whitepaperis to explain the effect of market volatility on the success of a retiree’s portfolio withdrawals over alifetime. The first section will detail some of the history of market volatility and explain how muchit has changed recently. The second section will then outline the problem as it pertains to aninvestor making regular distributions from a portfolio. The final section will draw some conclusionsand present ideas on how to minimize the impact of volatility and market uncertainty on thelikelihood of success in retirement.Day to day market fluctuations are higher now--particularly since the global financial crisis of 2008--than they have been in years past. Since the creation of the Dow Jones Industrial Average in 1896many days have been volatile. The past four years represent less than 3.5% of the total time sincethe index’s inception. Of the top 20 worst days in the market since 1896, 4 have fallen in the pastthree years1 . In other words, 20% of the worst days in the market have occurred in less than 3.5%of the time elapsed. The only other period in the last century with daily volatility higher than what weare seeing now was the Great Depression.Several factors have affected the persistently high stock market volatility in recent years. Attributionof market returns today is highly correlated to market sentiment, geopolitical news, broad macro-economic data and investor confidence. It appears that as sentiment and confidence erode, marketsare more and more affected by news. With no clear end in sight to the uncertainty in the worldeconomy, it appears that higher than average market volatility will last for some time.The problem that the market volatility presents to investors is not uniform. For an investor whosesole priority now is accumulating assets, volatility has little effect. As long as long-term averages areupheld, excess fluctuations in market values do not pose a problem. In fact, often portfolio volatilitycan be beneficial to an investor who continually adds to a portfolio. Market dips provide improvedpricing for asset purchases--buy low and sell high. One of the only potential drawbacks for aninvestor not taking distributions is the emotional reaction to market swings. Seeing a portfoliodecline by nearly 40% (as the S&P 500 did in 2008) can be a difficult experience. As long as an“accumulation” investor can stomach the downturns, the profits in the long-run can be great.1 Source: 610-234-2100 | |
  3. 3. Recovery Rates and the Effect of Market Volatility on Retirement SuccessThe problem arises, then, when an investor is distributing assets, rather than accumulating them. Theimpact of portfolio volatility on portfolio distributions can be pronounced.In modern portfolio management, there is no magic bullet to prevent failure nor to completelynegate the effects of market volatility on success. There are, however, several ways in whichinvestors can try to protect themselves from its effects.First, it is critical to plan for volatility in the markets. Regular, large market fluctuations havebecome the norm, rather than the outlier. In order to effectively construct a portfolio for incomedistribution, the first step is to understand that markets will be volatile. Perhaps in the coming yearsdaily fluctuations will return to lower, historical levels, or perhaps we have reached what someeconomists have termed the “new normal.” In either case, planning for excess volatility is animportant step in long-term success. It is much easier to plan for a higher volatility market and thenadjust portfolio allocations later than to assume steady market returns indefinitely.Broad diversification in a portfolio of assets is the first step to minimizing risk. Beyond the strategicallocations, though, tactical adjustments and regular rebalancing can have a positive impact. Ofteninvestors observe events leading up to excess uncertainty and fail to act.. In the face of risingpotential risks, it can be wise to make adjustments to a portfolio allocation, provided that the long-term goals are not sacrificed. The schedule of these changes is important as well. If an investoradjusts his portfolio once a year or at some other arbitrary temporal measure, it may have very littleor even a negative impact. The economy does not change on a set schedule. The market does notchange on a set schedule. They change when they change and investors need to be nimble and agile toavoid risks when they present themselves and to capitalize on opportunities when they arise.Alternative investments can also play a big role in long-term success for a retiree. Assets such asprecious metals, inflation protected bonds and commodities can add benefit to an investor’sportfolio since their prices do not move in lock-step with the stock market. By adding assets to aportfolio that fluctuate differently than the market, overall volatility can drop.Below are two tables of four hypothetical year-end values for a $1,000,000 portfolio over the pastfour full calendar years, the first without portfolio distributions, the second with a 4% annualdistribution adjusted each year for inflation. 610-234-2100 | |
  4. 4. Recovery Rates and the Effect of Market Volatility on Retirement SuccessPortfolio One is representative of the S&P 500. Portfolio Two is a simple, diversified blend of 60% S&P 500and 40% BarCap Aggregate Bond Index. Portfolio Three is a more broadly diversified portfolio of 50% S&P500, 40% BarCap Aggregate Bond Index, 5% S&P GSCI Diversified Trend Index2 and 5% Gold3.No Portfolio Distributions:Portfolio Starting Value $1,000,000 on 12/31/2007Values Shown are at Year-EndWhen no portfolio distributions are taken during a volatile period of time, the stock market doesrecover a good portion of what it loses during a downturn. The benefit of portfolio diversificationover those four years is nevertheless significant. A simple diversified mix of stocks and bonds overthat period would be worth $160,800 more than the S&P 500 portfolio, while a broadly diversifiedmix of stocks, bonds and alternatives would be worth $209,000 more.The effect is more pronounced when distributions are taken into account.With 4% Annual Distributions Adjusted for Inflation:Portfolio Starting Value $1,000,000 on 12/31/2007Values Shown are at Year-End2 The S&P DTI is an investable long/short strategy that can benefit from trends (in either direction) in the global futures markets. Itconsists of 24 futures contracts, with a 50% weighting in financial futures and 50% weighting in commodities futures.3 The sample portfolios are for illustration purposes only. Returns assumed are annualized index returns, gross of any fees. Actualreturns would be lower. You cannot invest directly in an index. 610-234-2100 | |
  5. 5. Recovery Rates and the Effect of Market Volatility on Retirement SuccessWith the 4% annual portfolio distribution, the S&P 500 portfolio is worth $165,300 less than thebroad stock and bond diversification and $213,800 less than the stock, bond and alternative mix.For a retiree distributing income over a lifetime, that difference in value over four years will have asignificant impact on expected distributions for the remainder of his or her life.Accounting for the increased market volatility over the past few years has been challenging for allinvestors, professional and otherwise. Planning for the long-term success in a distribution portfoliotakes careful attention to detail in both the planning and execution over time. The Wiley Group’sgoal has always been to minimize the short-term risks and to maximize the long-term probability ofsuccess in distributing assets for a lifetime. If you have any questions about how the recent marketvolatility may be affecting your retirement plan, please call the Wiley Group at 610-234-2100.Please remember that past performance may not be indicative of future results. Different types of investments involve varyingdegrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, orproduct (including the investments and/or investment strategies recommended or undertaken by Live Your Vision, LLC ), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any correspondingindicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to variousfactors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions orpositions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of,or as a substitute for, personalized investment advice from Live Your Vision, LLC. To the extent that a reader has any questionsregarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult withthe professional advisor of his/her choosing. Live Your Vision, LLC is neither a law firm nor a certified public accounting firm and noportion of the newsletter content should be construed as legal or accounting advice. A copy of the Live Your Vision, LLC’s currentwritten disclosure statement discussing our advisory services and fees is available for review upon request. 610-234-2100 | |