This post continues a series of thoughts on investment returns and misleading aspects of average annual returns. The articles started with my Tacoma News Tribune column June 4 and extended to include this post about cost basis returns.
Here, we look at how the sequence of investment returns becomes much more important when an investor has shifted to withdrawing assets rather than accumulating a retirement nest egg.
When you are accumulating assets, the order of annual returns doesn’t matter. Take the S&P 500 return of the past 10 years and apply it to an investment in any order you like.
|
2003 |
28.50% |
2008 |
-37.02% |
|
2004 |
10.74% |
2009 |
26.49% |
|
2005 |
4.77% |
2010 |
14.91% |
|
2006 |
15.64% |
2011 |
1.97% |
|
2007 |
5.39% |
2012 |
15.82% |
For example, if you start with $500,000 and apply the annual returns in sequential order, reverse order or any random mix, you will end 2012 with a balance of $982,188.30.
However, you cannot use the average annual return over this period and get the same result. The average annual return over this 10-year period is 8.72%. If you apply annual 8.72% compounded growth to the initial $500,000 you would have an ending balance of $1,153,624 – a positive difference of $171,436.
If you evaluate an investment by reviewing the average annual return, you can be easily led astray of reality. Even more problematic, if you apply an average annual return assumption to a retirement income projection, you could receive wildly misguided output.
The order of returns becomes much more important in the withdrawal years.
Consider this variation of the earlier example.
Start with a nest egg balance of $500,000 and take out $25,000 (5%) at the start of each year. For simplicity’s sake we won’t consider adjusting the withdrawals upward each year to offset inflation. Since you need the $25,000 for year one, the balance left invested is $475,000.
If we use the average annual return assumption, the balance at the end of 2012 is $721,159. Even though we removed $25,000 per year ($250,000 total), our ending balance increased nicely due to the assumed 8.72% annual return that was achieved from 2003-2012.
Now, not only is the average annual return misleading, but the sequence of those returns becomes important. If we do the math with the actual order that was experienced, at the end of 2012, the account balance is $611,575 – almost $110,000 less.
If we reverse the order of returns, the ending balance is $565,801.
What if we move that ugly -37.02% return from 2008 up to the first year of the assumed retirement (2003 in this case)? Even though the average return over the 10-year period remains the same, the order is detrimental to long-term financial security. After 10 years, the account balance has dropped to $440,976 – 39% less than the projected balance if simply applying the average annual return each year.
| Return sequence A | Return sequence B | Return sequence C | Return sequence D |
| 8.72% return each year | Actual order of S&P 500 returns 2003-2012 | Reverse order of S&P 500 returns 2003-2012 | Negative return first (2008’s -37.02 switches places with 2003 return) |
| End balance | End balance | End balance | End balance |
| $721,159 | $611,575 | $565,801 | $440,976 |
Stretch these examples out over 20+ years – more reflective of a full retirement – and you will see that even if you achieve the same average annual return over time, it’s possible that one order of returns could run out of money while a different sequence could more than offset the annual withdrawals with exceptional growth.
KEY TAKEAWAYS
- Average annual returns are not a good proxy for the actual investor experience.
- Using retirement calculators that rely on a simple average annual return assumption can be problematic. It’s important to use sophisticated enough analysis to generate many variations of return patterns. This way you can understand a range of possible asset projections and determine a probability that your money will last longer than you do.
- This example uses an investment only in the S&P 500 Index of large U.S. stocks. It is not a globally diversified portfolio and is not reflective of an investment strategy that we would recommend, either while accumulating assets or withdrawing from them.
- A globally diversified portfolio may have lower returns over time but also could be expected to experience less downside risk. This type of portfolio would not be expected to continue growing at the rate demonstrated here while withdrawals were also being made.
Have you determined how much money you’ll need to retire without too much concern about the impact of market returns?
How have you projected future account growth and the impact of withdrawals?
~ Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA
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