Reverse Dollar Cost Averaging and Sequence of Return Risks
Dollar Cost Averaging is pretty much the greatest thing since sliced bread when you are accumulating asset and saving for the future. It allows you to systematically invest month after month year after year removing the emotion for buying decisions and taking advantage of market downturns. For the average American it is best approach for saving and investing for your future.
But what happens when we flip the switch from accumulation to distribution? No big deal, it works the same, just in reverse, right? There is no need to make any big changes, you simply start pulling income in retirement, right? After all, if you average 7% in retirement and you take out 4% you will be earning more than you are taking and your portfolio will do just fine, right? The answer may shock you.
Let’s examine 2 retirement scenarios:
- Table A: John and Sally retire with $1,000,000 in assets. They decide to take 4% or $40k for income each year. The table assumes actual S&P500 total returns from 2000-2017 which averaged 7.03% per year.
- Table B: Jack and Jill retire with $1,000,000 in assets. They decide to take 4% or $40k for income each year. The table assumes actual S&P500 total returns from 2017-2000 which averaged 7.03% per year. Notice the only difference is that the sequence of returns, or order of returns, is the opposite of table A. Follow the arrows in the tables.
In both scenarios the average rate of return is the same at 7.03%. So they should end up with the same amount in their portfolios 18 years later, correct? No. The sequence of returns also known as the order of returns is very different and when you combine it with the income they are receiving in the form of Reverse Dollar Cost Averaging the results are drastically different. John and Sally (Table A) end up with $833,183 in their portfolio 18 years into their retirement while Jack and Jill (Table B) end up with $1,751,083 18 years into theirs.
Despite the fact that John and Sally’s investments averaged 7.03% over the 18 year timeframe and they have only taken out 4% of their initial investment annually, they are still down in value.
The results are even more drastic when you observe their values as of year 9. John and Sally (Table A) are in complete panic mode as their original $1,000,000 is now worth $414,417. However, Jack and Jill (Table B) are feeling great with a portfolio value of $2,892,003.
Reverse Dollar Cost Averaging works great when markets have positive returns, but really handicaps a portfolio when markets are down. Sequence of Returns can be vital to success or failure when we are taking withdrawals from your portfolio for income.
Ultimately we need to determine how we reduce this risk to our retirement health as well as our psychological well-being. Lets face it, declining markets are a big worry to many retirees. No one ever retired and said I want to have to change my lifestyle each year depending on my portfolio results. So how do we reduce this concern in retirement? Before answering that question directly lets talk about why we have saved and invested all these years to get us to retirement. It isn’t for the pleasure and satisfaction of looking at our portfolio balances on a daily basis is it? We accumulate assets for retirement so that ultimately those assets can provide a paycheck in retirement. In other words, it is about the income that our assets provide much more than the total value of the assets themselves.
Here is a revelation for you. The happiest people in retirement are not the people with the most assets, they are the people with the highest guaranteed income levels. Lets think about that for a second. The more assets we own that require positive performance in order for us to receive income the more worries we have. What are stocks, bonds, oil, gold, and real estate doing? There are a lot of things to worry about in the investing world but nothing makes an investor worry more about them more than when they are relying on them for income.
Why not reposition some of your retirement portfolio into products that cannot go down in value or can provide a guarantee on income for life? Longevity risk which is the risk that you will live a long time in retirement can also be reduced or eliminated with this strategy as well. Investing in our distribution years can and should be different than in our accumulation years. Why is it so easy to “ride it out” during the tough times in the market when you are working? The answer is simple. Because your income is not determined by your investments. As a seasoned Advisor I have seen highly experienced aggressive investors turn into crying children the minute they retire and market has a hiccup. There is no need for this risk or self-imposed psychological turmoil. By repositioning assets into guaranteed income annuity products we can reduce or even eliminate Reverse Dollar Cost Averaging risk from your retirement landscape. Think about it, if you had retired in Jan of 2008 and the market crashed right away what would you do? Would you immediately change your lifestyle by cutting out things like travel and other fun ways to spend your money? Is that why you retired? No of course not. You want to be able to do all the things you have dreamed about in retirement and those should not be dependent on your portfolio values.
Protecting against market downside or guaranteeing yourself income for life are great ways to reduce the many risks that are unique to retirement income investing.