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Protect Your Clients From the Retirement Income Death Spiral

By John Manganaro

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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.

The first portfolio began its retirement income journey in 1957 with a 2.7% loss, then had the same returns in the same order for 25 years as the second portfolio, which began its journey in 1958.

“Distributing wealth is a nonlinear process governed by the laws of chaos theory, including the butterfly effect, which says that even seemingly insignificant changes to inputs early in a process can cause dramatically different outcomes in the long term,” Sandidge writes. “[The example] illustrates this because the 2.7% loss in the first year is why the 1957 retiree finished year 26 (1982) with 1.2% of the original principal ($12,352) compared with the 1958 retiree, who finished the same year with 51.4% ($514,419).”

This result is enlightening in its own right, but Sandidge says the bigger insight comes from examining the experience of the unfortunate 1957 retiree in the latter third of their income journey.

“The [first portfolio] still had more than 50% of principal ($506,410) after 20 years,” Sandidge points out. “Maintaining that pace of principal erosion should mean the portfolio would last another 20 years, but after six more years it only had $12,352 left.”

The key insight is to realize that negative momentum built to a critical point where a small 2.1% loss in 1977 became the straw that broke the camel’s back, “plunging the portfolio into turbulence and accelerated principal erosion.”

The end result is that the 1957 retiree burned through 49.4% of the original principal during the first 20 years and the same amount during the next six years.

“I often hear the first five years of retirement described as a retirement red zone,” Sandidge adds. “The butterfly effect does make those early years important. But [this result] shows that a retiree operates with a much smaller margin for error throughout retirement because the 2.1% loss that triggered the accelerated erosion for the 1957 portfolio came in year 21.”

The Communications Takeaway

As Sandidge stressed, focusing on the most simplifying axiom — that early negative returns matter — is also the key to clearer advisor-client communication when it comes to discussing retirement income risks, “as most people can only hold three to five chunks of information in their working memory.”

“If you exceed that, they get confused and won’t remember anything,” Sandidge said. “The term ‘sequence of returns risk’ is likely new jargon to many retirees and as such will occupy one of their limited pieces of working memory.”

Conversely, many retirees are probably already familiar with the concept of “market losses,” Sandidge said, so talking about that will draw from their long-term memory and preserve working memory.

“Advisors need thought leadership that can easily be repeated to a novice investor and have the investor reach a certain level of understanding,” he argued. “Overwhelming them with superfluous information and unnecessary jargon will lead to mental dazzle rather than enlightenment.”

Pictured: James Sandidge

John Manganaro

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