Consider the example shown in table 4, which shows someone who
retired at the end of February 2008 with a 60/40 portfolio taking a
market loss of 26. 8 percent in the first twelve months of retirement.
Withdrawing 5 percent and paying a 1-percent fee that first year,
this retiree would have seen approximately 32. 8 percent of his life
savings disappear in the first year of retirement—the type of catastrophic loss that could create a cascade of principal erosion that a
portfolio is unable to recoup. That type of loss, coupled with hypersensitivity to losses, may cause retirees to panic and abandon their
strategies by selling low.
With a smaller asset base ($672,000 versus $1 million), the original
$50,000 annual income falls to $33,600 the second year to maintain
the 5-percent withdrawal rate. Thus the “risk three-step”—a rapid
reduction of principal, followed by a reduction in cash flow, followed
by investor panic. Many retirees likely can tolerate gradual principal erosion, but many fewer would find a 33-percent drop in principal and cash flow acceptable after one year of retirement.
Retirees Cannot Count on Time for Risk Management
There are no second chances with retirement savings. When saving
for retirement, time provides a safety net against short-term risk.
But retirees cannot count on time, so it’s critical to get the risk
allocation right. Figure 3 shows year-by-year account values for a
portfolio allocated 70/30 beginning in 2000. The black line shows
that an investor who was accumulating wealth was able to recover
from two of the worst stock markets in the past seventy-five years
(2000–2002 and 2008–2009) to finish the fourteenth year with
153 percent of the original investment.
With time as a safety net, “focus long-term” or “sit tight” have been
effective risk-management strategies for those accumulating wealth.
Conversely, the bars show that if the same investor employed the
same portfolio to distribute wealth with a 5-percent initial withdrawal and 3-percent annual increases, the account value never
recovers from the early market losses and finishes the fourteenth
year with only 26 percent of the original investment, a pace of principal erosion that could deplete the account in five more years.
Accumulating investors only have to worry about how long it
would take to recover from losses. Retirees must worry about
losses triggering accelerated principal erosion and cash-flow risk,
and the lack of a safety net exaggerates the importance of even
small adjustments to risk.
The Butterfly Effect
The butterfly effect refers to the ability of small changes early in a process that lead to significant impact later. It gets its name from the idea
that a butterfly flapping its wings in Brazil could trigger a chain of
events that would culminate in the formation of a tornado in Texas.
The butterfly effect applies to distribution portfolios where even small
changes early in retirement can have significant impact long-term.
Table 5 compares two accounts after twenty-five years of accumulation (column two) and twenty-five years of distribution (column
three). The account allocations are identical except in year one,
when the first used a 50/50 allocation and the second used 30/70;
both used 50/50 every year after. That small difference in risk allocation changed the first-year return from − 2. 9 percent to −0.04 percent and increased the ending accumulation value from $5,666,874
to $5,836,534 (a 2.9-percent increase).
Table 4: Impact of Large Losses in Retirement
– 26.8% 60/40 market loss March 2008–February 2009
– 5% $50,000 withdrawal
– 1% Fee
= $672,000 New account value after 32.8% principal erosion
5% withdrawal of new account value =
$33,600 distribution year two
Figure 3: Time Waits for No One
Table 5: The Butterfly Effect and Risk Allocation
after 25 Years
after 25 Years
50/50 every year $5,666,874 $94,532
30/70 year one,
then 50/50 $5,836,534 $264,191
Assumes $1-million investment in 1966. *Distribution assumes 5-percent initial withdrawal with 3-percent annual increases.
Table 6: The Butterfly Effect and Fees
after 25 Years
after 25 Years
1.5% $3,322,256 $95,865
1% $3,743,020 $312,650
Assumes $1-million investment (50/50) in 1957. *Distribution assumes 5-percent
initial withdrawal with 3-percent annual increases.
Year-by-Year Account Values 2000–2013
$1m Investments, 5% Withdrawals Increased 3% Annually
70/30 Distribution 70/30 Accumulation