Retirement’s Volatility Bogeyman

Retirement’s Volatility Bogeyman
March 7, 2012

Investment marketing is like watching a talented magician ply his trade. While the marketing geniuses keep everyone focused on the hottest new funds and stocks in an effort to chase strong returns, people forget about the single most important thing that matters to your retirement portfolio: volatility.

So let’s be crystal clear: retirement sustainability is extremely sensitive to portfolio volatility. Further,  volatility is the only portfolio outcome that we can actively control. Therefore, volatility is the critical variable in the retirement equation, not returns.

To repeat: Volatility is the critical variable in the retirement equation, not returns.

Forget Returns; It’s About SWR and RSQ

If you’re within 5 years of retirement, or are already in retirement, it’s time to learn some new vocabulary:

Safe Withdrawal Rate (SWR): the percent of your retirement portfolio that you can safely withdraw each year for income, assuming the income is adjusted upward each year to account for inflation.

Retirement Sustainability Quotient (RSQ): the probability that your retirement portfolio will sustain you through death given certain assumptions about lifespan, inflation, returns, volatility and income withdrawal rate. You should target an RSQ of 85%, which means you are 85% confident that your plan will sustain you through retirement.

Forget about investment returns! From now on, the only question a retirement focused investor should ask their Investment Advisor when discussing their options is: How does this effect my RSQ and SWR?

Portfolio Volatility Determines RSQ and SWR

The chart below shows how higher portfolio volatility results in lower SWRs, holding everything else constant:

  1. All portfolios deliver 7% average returns
  2. Future inflation will be 2.5%
  3. Median remaining lifespan is 20 years (about right for a 65 year old woman).
  4. We want to target an 85% Retirement Sustainability Quotient (RSQ).

Note how SWR declines as portfolio volatility rises.

The green bar marks the volatility of a 50/50 stock/U.S. Treasury balanced portfolio over the long-term, while the red bar marks the long-term volatility of a diversified stock index. Note the SWR of the stock/bond portfolio is 6% versus 3.4% for the stock portfolio, highlighting the steep tax volatility levies on retirement income.

Steady Eddy and Risky Ricky

This is actually quite intuitive when you think about it. Imagine a scenario where two retired persons, Steady Eddy and Risky Ricky by name, draw the same average annual income of $100,000 from their respective retirement portfolios. Both draw an income that is a percentage of the assets in their retirement portfolio at the end of the prior year.

Steady Eddy’s portfolio is invested in a balanced strategy with a volatility of 9.5%, while Risky Ricky is entirely in stocks with a volatility of 16.5%. Both portfolios earn the same return (as they have done for the past 15, 20 and 25 years, though we will address this in greater detail below).

Due to the lower volatility of Steady Eddy’s portfolio, his income is less volatile: 95% of the time his income is between $82,000 and $117,000. In contrast, Risky Ricky’s portfolio swings wildly from year to year, and therefore so does his income: 95% of the time his income is between $67,000 and $133,000. Of course, both of their incomes average out to the same $100,000 per year over time.

All other things equal, which person would you expect to be more conservative in the amount of income they spend each year? Obviously, if your income were subject to a large amount of variability each year then you would tend to be more conservative in your spending; perhaps you would squirrel away some income each year in case next year’s income comes in on the low end of the range.

This relates directly to the impact of volatility on SWRs in the chart above. Volatility introduces uncertainty which is amplified by the fact that money is being extracted from the portfolio each and every year regardless of portfolio growth or losses.

How Much Gain Will Neutralize the Pain?

Of course, this effect can be moderated by increasing average portfolio returns, which would then increase average available income. The question becomes, how much extra return is required to justify higher levels of portfolio volatility?

The chart below defines this relationship quantitatively by illustrating the average return that a portfolio must deliver to neutralize an increase in portfolio volatility. In this case we hold the following assumptions constant:

  1. Withdrawal rate is 5% of portfolio value, adjusted each year for inflation
  2. Inflation is 2.5%
  3. Retirement Sustainability Quotient target is 85%
  4. Median remaining lifespan is 20 years
Again, the green bar represents the balanced stock/Treasury bond portfolio discussed above, and the red bar represents an all-stock portfolio. From the chart, you can see that the balanced portfolio needs to deliver 6.8% returns to achieve an 85% RSQ with a 5% withdrawal rate. The higher volatility stock portfolio, on the other hand, requires a 9.2% returns to achieve the same outcomes.
In theory, higher returns in your retirement portfolio should equate to higher sustainable retirement income. In reality, higher returns at the expense of higher volatility actually reduces your retirement sustainability.
Focus on What You Can Control
There are many ways of improving the ratio of returns to volatility in a portfolio, mainly through thoughtful diversification across asset classes (our particular specialty). However, many investors are (perhaps rationally) concerned about diversifying into bonds now that the long-term yield is 3% or less, so let’s see what can be done with a pure stock portfolio to take advantage of the growth potential of stocks while keeping volatility at an appropriate level to maximize RSQ and SWR.
What if, instead of letting the volatility of the stock portfolio run wild, we set a target volatility for our portfolio and adjust our exposure to stocks up and down to keep the portfolio volatility within our comfort zone.

For example, let’s set a target of 10% annualized volatility, so if stock volatility is 20%, our allocation to stocks =  target vol/observed vol = 10% / 20% = 50%, with the balance in cash. If stock volatility drops to 15%, our allocation would be 10% / 15% = 66.6% invested, with the balance in cash.

For the purposes of this example, we will assume that cash earns no interest, because it currently doesn’t, and we want to focus on the effect of managing volatility alone.

More specifically, let’s assume we measure the trailing 20-day volatility of the SPY ETF (which tracks the performance of the U.S. S&P500 stock market index) at the end of each month, and adjust our portfolio at the end of any month where observed volatility is 10% above or below the volatility we measured at the end of the prior month.

For example, if we measured volatility last month at 15% annualized, and the volatility this month was greater than 16.5% or less than 13.5% (10% either way from the prior month), then we adjust our exposure to the SPY ETF according to the most recently observed volatility using the technique described in the last paragraph. If this month’s volatility does not exceed the threshold to rebalance, then we do not trade this month.

By using this simple technique to control volatility since the SPY ETF started trading in 1993, we achieve 6.65% annualized returns with a realized average portfolio volatility of 10.73%. This compares with returns on the buy and hold SPY ETF of 7.99% with a volatility of 20%. Note that our average exposure to the market over that period was just 69%, with the balance earning no returns. All returns include dividends.

The chart below shows the Sustainable Withdrawal Rate for the two portfolios: the volatility target SPY and the buy and hold SPY.

Source: Butler|Philbrick|Gordillo & Associates, 2012, Algorithms by QWeMA Group.

You can see that by specifically targeting portfolio volatility our sustainable withdrawal rate rises to 4.7% per year, adjusted for inflation (at 2.5%) versus the Buy and Hold portfolio which will support a withdrawal rate of 3.65% per year. This despite the fact that the Buy and Hold portfolio outperforms the volatility-targeted portfolio by 1.35% per year.

We can’t control the returns that markets will deliver in the future, but we can easily control portfolio volatility by observing and adapting. Withdrawal rates from retirement portfolios are highly sensitive to this volatility, and we have demonstrated that by controlling volatility we can increase our safe withdrawal rates, and therefore boost retirement income, by almost 30% before tax.

Just imagine what’s possible with a diversified portfolio of asset classes when you volatility-size them. But… that’s for another article.