Do you know what has been one of my favorite parts of writing a blog?
Has it been diving into the detail on some area of research that I’ve always wanted to investigate? Or is it receiving kind words from my readers who share my enthusiasm? Or is it having fellow actuaries reach out and offer support for my mission? (ooooh it’s a ‘mission’ now? Well la-de-da!)
Nope, it’s getting down and dirty with the numbers and the models!
Seriously though; I certainly enjoy building the models and investigating the results, but can you let me know if anything is inaccessible? Because this stuff can polarize people, and I want everyone to be able to take away something from this blog, irrespective of whether you are a numbers person or not. I’m not talking about dumbing things down, I’m talking about getting sophisticated messages across in a fun way that doesn’t blow up your brain (or mine).
Have you read the important notes? It’s a condition for reading this blog.
Inflation Risk Series
Were you expecting the next episode in the series of Inflation Risk for Early Retirees that Karsten/ERN and I have been running? Following Karsten’s last episode I had to lie down in a darkened room and digest it all, and I’ll be coming back at some point with a new episode, so stay tuned! But here is my last episode on personal inflation rates when you have read ERN’s.
Sequence of Returns
Let’s get back to sequence of returns.
Since starting this blog I have become totally obsessed with sequence of returns (SOR). I am planning a new article on this subject that will take a novel view on the classic ‘Trinity Study’ but first I wanted to do a short primer on sequence of returns in preparation. I have many new readers that may not have seen some of my early articles on the subject, here and here So I think it is worth a quick review.
Sequence of returns addresses the fact that it’s not just the value of stock and bond returns that are important in retirement, it’s also how those returns are sequenced that can have a big impact on your retirement success. Enduring a significant market crash early in your retirement can be much more damaging than experiencing it later in retirement if you continue to drawdown your portfolio at the same rate.
I’m not going to discuss ways to mitigate this risk today, but instead I’m going to look at one aspect that can make this risk more acute…. buying a boat.
Quantifying Sequence of Returns Risk
First we need to quantify SOR and how it might impact on our retirement success.
I’m going to look at a 50 year retirement period and take a portfolio of 70% stocks and 30% bonds, and simulate using real returns over the last 50 years. Here is the results showing the growth of a $1,000,000 portfolio.
Over the last 50 years it would have grown to a huge $12m sum. And that’s in real terms! In order to look at the impact of sequence of returns I’m going to scramble up those 50 years’ of returns in a different order?
Because over the period the total return will still be same, but only the sequence of returns will differ. Here is a chart showing 100 different versions of these 50 returns, and you can see that the $1m still rolls up to the same $12m sum. that’s just math.
It’s not until you start introducing withdrawals from the portfolio that you see the impact of SOR. Here is the same simulation with $40k withdrawn every year.
There is suddenly a big spread in ending values! And there are even some values that have gone to zero. That is the power of SOR. Remember that the total return for equities and bonds for all these simulations is identical – only the SOR has changed.
In fact in my simulations I found that the 4% rule failed around 11% of the time for this 50 year time horizon and using 10,000 different SOR simulations of the last 50 years’ of returns. So let that sink in for a minute. Just by changing the SOR the 4% Rule is not so safe. But that will be a subject of another post. Let’s now look at boats.
Buying a Boat
So what has this got to do with buying a boat?
Well, it doesn’t have to be a boat, but that’s just actuarial shorthand for retiree profligacy. If you are considering any kind of capital outlay in retirement how could SOR impact your overall retirement solvency?
We know from the above example that cashflows will magnify SOR. So how does buying a boat (or any large purchase) impact the SOR risk in retirement?
I’m going to look at four situations, and in all cases I will start the simulation with $1m.
- Not buying a boat and just have regular spending of $40k a year.
- Buying a boat worth one year’s spending ($40k) along with regular spending.
- Buying a boat worth two year’s spending ($80k) along with regular spending.
- Buying a boat worth three year’s spending ($120k) along with regular spending.
Don’t get hung up on the actual dollar amounts here. You might not have $1m in your retirement pot, you might have much more, or much less. You also might not be interested in a boat. The point is that we are looking at a large capital purchase worth a multiple of your annual spend. It might be a boat, it might be a down payment on a house, or fees to go to actuary school, so just go with it ok?
Also it might not be a pleasant thing… You might have a large capital outlay due to a medical emergency. So it’s useful to understand how this might hurt your retirement success.
Hey! Do you want to get updates when I make a new post? Want to get all that actuary-speak direct to your front door? Just sign up with the email signup thingy. Also follow me on Twitter @actuaryonfire
Impact of SOR on Your Boat Purchase
The key measure I am going to use is whether you run out of money in the 50 years. In actuary circles we call this “solvency probability” (oooooh I love it when we talk all actuary-like!).
This might sound odd, but remember that I’m not really interested in the absolute probability of success, I’m interested in the relative impact on success of buying a boat. In particular, I’m interested in how SOR will affect this success. There is loads of information out there about the probability of success of a 4% withdrawal rate over different time periods and using different investment strategies. See for example ERN’s SWR series.
Also remember I’m not looking at different historical time periods. I’m only looking at one time period, and that is the last 50 years’ of returns. But I take 10,000 different permutations of these returns. It sounds crazy, but this ensures that the total return for each simulation is identical, and only the sequence of those returns has changed.
Let’s look at the results.
The above shows the impact on the probability of retirement success from buying various boats at different points in your retirement whilst continuing to maintain a $40,000 per year withdrawal.
Suppose you buy a boat worth one year’s spending in year 10 of your retirement. You can see that this will reduce your probability of success by around 2% simply from SOR and the additional spend. That’s not a big impact, because it’s a pretty small boat, and quite a long way into your retirement.
Now look at buying a really large boat worth three year’s of spending in the first year of retirement. The reduction in probability of success is now almost 12%, just from SOR and the additional spend. In other words, you are 12% more likely to run out of money compared to the baseline of regular $40k a year spending. This is a material impact on your retirement success.
If you want to make a large capital outlay in retirement then there is no doubt that it will reduce your chance of remaining solvent. However if you are only spending about one year’s worth of spending as a special project then that might only reduce your success probability by 2-3%. Not much.
However if you’re planning to spend 2-3 times your annual spend on a special project then that could materially impact your chance of retirement success. It might reduce your probability anywhere from 8-12% compared to the baseline of constant spending.
Are you planning to make a capital expenditure in retirement? Have you simply wrapped that in your total assets, or have you carved it out, and think about your annual income retirement assets differently to a one-off spend? Are you a not a numbers person, but still want to get something out of this blog? Drop me a line or comment below. Thanks!
(c) Actuary on FIRE 2018