What You Need to Know
- New research reveals a key risk that isn't obvious in typical Monte Carlo simulations.
- The danger of rapid portfolio depletion in the second half of retirement is particularly easy to overlook or misinterpret.
- Make sure your clients understand that negative returns matter, especially early in retirement, James Sandidge says.
Financial advisors who rely solely on Monte Carlo simulations in the retirement income planning process may be overlooking a serious risk that can lurk unseen beneath the binary probabilities of success and failure: the retirement income death spiral.
This is according to the ongoing research of advisor and attorney James Sandidge, principal at The Sandidge Group. In a new conversation with ThinkAdvisor, Sandidge detailed the results of his latest paper, in which he defines the income “death spiral” and offers up some different ways advisors can help their clients foresee (and ideally avoid) later-in-life insolvency.
To summarize his findings, Sandidge says many people assume the experience of going broke in retirement is something that unfolds slowly and steadily over time, with easy-to-see warning signs all along the way. The reality is quite different, Sandidge says, as the second half of portfolio depletion often happens much quicker than the first — over the span of just a few years — and it doesn’t just happen to the smallest portfolios.
It is only by acknowledging these dynamics early on in the retirement journey that advisors can help their clients make the necessary adjustments to avoid a plunge into insolvency, for example by forgoing inflation adjustments in years with even minor market losses or skipping a seemingly sensible increase in withdrawals after a particularly good year.
Far from suggesting such advisors should abandon the practice of binary Monte-Carlo based planning, Sandidge urged them to consider how alternative means of analysis can help to better inform the income planning effort while also helping advisors do a better job of communicating about tricky topics, such as sequence of returns and longevity risk. One can learn quite a lot, he argued, by looking in granular detail at the experiences of retirees as they navigated real patterns of withdrawals and market returns in the past.
Sandidge, whose prior research on income planning has been featured by the Social Science Research Network, noted that his forthcoming paper has been accepted for publication by the Investments & Wealth Monitor and should offer some food for thought for advisors who rely heavily on Monte Carlo-based planning.
What Exactly Is the Death Spiral?
According to Sandidge, the most important thing for advisors to understand and communicate to their clients is that “negative returns are the simplifying axiom of retirement income,” especially early negative returns.
As he writes, “Retirement income portfolios fail when they reach a critical point where the negative momentum created by market losses, withdrawals and fees overwhelms the positive momentum generated by positive returns.”
In other words, when plans fail, it is generally not a smooth transition from sustainable to failure, because principal erosion tends to accelerate abruptly, throwing the portfolio into a “death spiral” that can be difficult to correct if not acknowledged quickly.
“Focusing on that fact will facilitate innovative solutions and retirement income conversations that resonate with retirees,” he said.
A Tale of Two Retirees
The central mathematical concept behind identifying the death spiral and its possible effects is what Sandidge refers to as the “momentum ratio” that is measured by dividing the sum of negative percentage changes in an account’s value by the sum of positive changes.
When he applied the “MoRo” to historical portfolios going back to 1900, he found that those portfolios with ratios of more than 100% during the first 15 years, those with 125% during years 16 to 20, and those with 150% during years 21 to 25 had a high failure rate. Conversely, those with ratios below these thresholds had a high success rate.
From this baseline, the analysis goes on to consider the year-by-year account values for different retirement portfolios that began with $1 million and a portfolio allocated 50-50 across stocks and bonds. The scenarios assume 5% starting withdrawals, increased by 3% annually to account for inflation and with a 1.5% annual fee.