When the markets crashed during the credit crisis, it exposed a massive problem with the way some people look at financial planning projections. Simply put, many financial plans use a static rate of return which assumes you receive the same percentage gain every year in your portfolio. In reality, we know that portfolios are anything but static and predictable.
The market crash delayed plans for investors who were nearing retirement, especially if they were heavily invested in equities. Worse still were the situations of people who were already retired and abruptly forced to re-enter the workforce.
Their financial plans had said that if they could get, for example, an average 6 per cent rate of return, they would be fine. It's possible that their portfolio's rate of return averaged 6 per cent over the course of their investing lifetime but depending on when the real world dips occurred and with what amplitude, some people reached their targets while others did not.
Let's look at a sequence of returns and see what effect this has on portfolio performance. In this case we are starting with $100,000 invested with $10,000 being withdrawn annually at the end of the year. The average annual return in both scenarios is 2 per cent. The only difference is that the portfolio on the left has all the positive return years occurring first. The portfolio on the right has all the negative return years occurring first.
|
Annual Return |
Portfolio Value |
Annual Return |
Portfolio Value |
||
|
Year 1 |
6% |
$96,000.00 |
|
-10% |
$80,000.00 |
|
Year 2 |
2% |
$87,920.00 |
|
-8% |
$63,600.00 |
|
Year 3 |
10% |
$86,712.00 |
|
-10% |
$47,240.00 |
|
Year 4 |
15% |
$89,718.80 |
|
6% |
$40,074.40 |
|
Year 5 |
2% |
$81,513.18 |
|
2% |
$30,875.89 |
|
Year 6 |
5% |
$75,588.83 |
|
10% |
$23,963.48 |
|
Year 7 |
8% |
$71,635.94 |
|
15% |
$17,558.00 |
|
Year 8 |
-10% |
$54,472.35 |
|
2% |
$7,909.16 |
|
Year 9 |
-8% |
$40,114,56 |
|
5% |
-$1,695.38 |
|
Year 10 |
-10% |
$26,103.10 |
|
8% |
-$11,831.01 |
As you can see, someone withdrawing funds from a portfolio benefits from stronger early returns, but is penalized heavily for poor early returns. Ergo, average rates of return are almost meaningless.
This example helps highlight the problem with using static rates of return. The sequence of returns factors very prominently into the success of a financial plan projection and must therefore be addressed for a proper retirement analysis.
There are two main ways to factor in the variability of returns in a financial plan. You can model a few worst-case scenarios to shock test your projections using a simple spreadsheet like the one above. You could incorporate significant negative years or stretches of negative years and play with the sequence of returns to give you an idea as to the robustness of your plan.
Alternatively, you can run thousands of projections using special modelling software available to financial planners today. They not only calculate the poor outcomes, they calculate what could happen if the stars are aligned in your favour.
Understanding the variability of returns becomes more important the closer you are to retirement. It might be a bit of overkill for a thirtysomething, but as you near the end of your working life it becomes mandatory.
The future isn't static and predictable, so why would you settle for that with your financial planning projections?
Preet Banerjee, B.Sc, FMA, DMS, FCSI is a W Network Money Expert. You can follow him on twitter at @PreetBanerjee
Preet Banerjee