One of the most difficult aspects of investing is determining how much risk to take in your portfolio at various stages of life. For instance, portfolio losses during the preretirement accumulation phase are easier to recover from than losses during the post-retirement distribution phase.
The mechanics of an investment portfolio are very different during the distribution phase. Losses are more difficult to recover from because withdrawals only serve to exacerbate the problem.
As shown in the Math of Recovery chart below, a post-retirement distribution portfolio faces a much steeper climb back to break even after a loss than does an accumulation (or buy-and-hold) portfolio. As shown by the shaded boxes, an accumulation portfolio only needs an average annual return of 7.7% to recover from a 20% loss within three years.
But a distribution portfolio, in which money is withdrawn each year, must generate at least a 16.5% average annual return over a three-year period to recover from the same loss. (This distribution portfolio assumes a starting balance of $500,000, an initial withdrawal at the end of the first year of 5% - in this case, $25,000 - and an annual 3% increase in the withdrawal amount.)
The conclusion is quite clear: When building a distribution portfolio for the post-retirement years, it is vitally important to avoid large losses. An investor's post-retirement portfolio must therefore be more loss resistant than the portfolio designed for the early accumulation years. But at the same time, the retirement portfolio must be able to provide sufficient return to preserve and/or grow the portfolio's asset base.
How is this to be done? Examine the performance of various asset allocation models that could be employed to build retirement portfolios.
COMPARING SIX PORTFOLIOS
For this analysis, six asset allocation models in distribution mode were tested to simulate the experience of an investor in retirement, with money being withdrawn from the portfolio (in this case, at the end of each year).
As shown in the 15-Year Retirement Portfolio Survival Test chart on page 67, the asset allocation models were as follows:
* 100% cash (defined as a money-market mutual fund)
* 50% cash/50% bonds
* 60% large U.S. stock, 40% bonds
* 25% each in large U.S. stock, non-U.S. stock, bonds and cash
* A 12-asset diversified model
* 100% large U.S. stock
The time frame of the analysis was the 15-year period from Jan. 1, 1998, to Dec. 31, 2012. The simulated retirement portfolios had a beginning balance of $500,000, although the actual amount is immaterial - the only investor-controlled variables that matter in this analysis are the initial withdrawal rate and the annual cost of living adjustment.
The initial withdrawal rate was set at 5%, or $25,000 at the end of the first year. The annual cost-of-living adjustment was 3% - so the second year's withdrawal was $25,750, the third year's was $26,523, and so on. (This analysis is not intended to endorse or discredit a 5% withdrawal rate.)
Additionally, all the multiasset portfolios were rebalanced back to their percentage allocations at the end of each year.
HOW THEY STACK UP
As shown in the chart, the 100% cash portfolio had a year-end account balance larger than the starting balance of $500,000. After the third year, however, the portfolio's annual ending balance was underwater, or below $500,000 (as illustrated below). By Dec. 31, 2012, the account balance of the all-cash portfolio was $223,941. Over the 15-year period, the internal rate of return - a way to measure the portfolio's returns during a period of withdrawals - was 2.65%.
For a retiree hoping to fund a 25-year (or longer) retirement period, an all-cash asset allocation will likely not get the job done - particularly in a low interest rate environment like the current one.
The next portfolio was a 50% cash/50% bond model, with bond performance represented by the Barclays Capital Aggregate Bond Index. As expected, it outperformed the all-cash portfolio, but was underwater beginning in 2004. The ending account balance in December 2012 was $344,395. The 15-year internal rate of return improved to 4.15%.
Next was the classic 60/40 balanced portfolio: 60% U.S. large-cap stock (as defined by the S&P 500) and 40% U.S. bonds (using the Barclays bond index). This ubiquitous model was underwater at the end of 2002, resurfaced for several years, and then after 2008 again slipped below $500,000. The ending account balance was $433,566, reflecting an internal rate of return of 5.07%.