Engineering a better retirement portfolio

Columbia Management, Investment Team | June 4, 2013

  • Experiencing a significant portfolio loss in the early retirement years (timing risk) is one of the greatest risks to the longevity of a retirement nest egg (shortfall risk).
  • This risk is typically a function of being concentrated in the wrong asset class — any asset class — at the wrong time.
  • By looking at a portfolio through a risk lens, investors can gain valuable insight into building a portfolio that minimizes concentration risk and can increase the chances of achieving retirement success.

The vast majority of investors approaching retirement are waking up to the sobering reality that their nest egg may fall short of being able to comfortably fund their retirement years. The combination of undersaving, low interest rates and a decade of challenging stock markets has created a personal retirement funding deficit that has many struggling to find a way out. Unfortunately, there is no silver bullet. A solution will likely require pulling a number of different levers; working longer, spending less and relying on greater support from others are just a few of the options, although none are terribly appealing. How you invest your nest egg is one lever you may be able to pull rather painlessly to help improve your retirement funding outlook.

The interaction of portfolio volatility and bad timing increases shortfall risk

Investors need positive returns to increase the probability of meeting their withdrawal needs throughout retirement. The risk of not meeting these needs is known as “shortfall risk.” And once a reasonable withdrawal rate is established, the biggest driver of shortfall risk is a large drawdown early in the retirement years. Withdrawing funds during this early losing period — thus, realizing the losses — means less capital working for the retiree when the portfolio recovers. If these losses are severe and/or prolonged, the long-term effects on the portfolio can be devastating.

Exhibit 1 looks at two scenarios for the full decade from January 2000 to December 2009. The green line represents someone who began their retirement withdrawals from a 60/40 portfolio (i.e., 60% stocks, 40% bonds) at the beginning of the decade, and who seeks to close a $1,500 per month retirement income gap by drawing on this portfolio.* That withdrawal amount is then adjusted for inflation in subsequent months. The orange line represents the cumulative return of the 60/40 with no withdrawals.

Exhibit 1: Comparing returns of the 60/40 on a $300,000 initial investment with and without $1,500/month withdrawals (adjusted for inflation): 2000–2010


Sources: Columbia Management Investment Advisers, LLC and Datastream, as of 12/12
Past performance does not guarantee future results. The 60/40 is defined as 60% S&P 500 Index/40% Barclays U.S. Aggregate Bond Index, rebalanced monthly. This illustration assumes reinvestment of all income and does not reflect sales charges, fees or expenses. This example is for illustrative purposes only and is not representative of the performance of any particular investment or product. It is not possible to invest directly in an index.

 

The 60/40 with no withdrawals weathered two equity market crises and grew to approximately $376,000 in aggregate. The 60/40 used to fund retirement provided $206,442 in withdrawals. However, the portfolio was drawn down to just under $138,000, which means it missed out on more than $30,000 in portfolio gains ($376K–$206K = $170K vs. $138K actual). Therefore, when the Tech Bubble burst in the early 2000s, the portfolio’s recovery power was meaningfully diminished at an early stage in the investor’s retirement. In other words, shortfall risk was increased and the longevity of the retiree’s nest egg was jeopardized.

What if our retiree was born and retired 10 years earlier? Exhibit 2 includes the full 20-year window of the 1990s and 2000s.

Exhibit 2: Comparing returns of the 60/40 on a $300,000 initial investment with and without $1,500/month withdrawals (adjusted for inflation): 1990–2010


Sources: Columbia Management Investment Advisers, LLC and Datastream, as of 12/12
Past performance does not guarantee future results.
 

Here, our hypothetical retiree was fortunate. The initiation of their retirement withdrawals happened to coincide with the start of a decade-long equity bull market. The compounding of these strong gains in the early years of retirement meant the retiree built up a significant enough cushion to weather the market downturns of the 2000s. Shortfall risk for this retiree is therefore very low.

Concentrating your risk in the wrong asset class at the wrong time can be devastating

Through the examples above, it becomes clear that shortfall risk is a function of timing risk, and timing risk depends on the market environment and how your portfolio is invested at any given point in time. And the intersection of bad timing and portfolio concentration in any single asset class can do irreparable damage when the drivers of that asset class turn sour. In our paper, Rethinking How We Invest, we introduced the concept of allocating portfolios according to risk rather than dollars. The key conclusions of that paper include:

  • Allocate risk, not dollars, to asset classes that respond independently to different economic and market drivers. By balancing risk to asset classes that respond independently to different types of economic and market environments, we can build a portfolio that will perform more consistently across the different phases of the economic cycle.
  • By balancing risk among asset classes with low correlation, we can improve portfolio consistency.** A higher Sharpe ratio — the ratio of excess returns above cash divided by the portfolio volatility — means you are rewarded more consistently for the risk you take. The more consistent the return experience, the less painful the periods of losing money, and, in a retirement income context, the lower the timing risk (and, hence, lower shortfall risk).
  • The responsible use of leverage can allow you to target higher levels of return without concentrating the portfolio. Targeting higher levels of return has historically meant increasing portfolio concentration in high-risk assets, such as equities. But we can target higher levels of return without concentrating the portfolio by applying modest amounts of leverage to low volatility, diversifying asset classes.

Improve your chances of achieving retirement success through better portfolio engineering

After a professional lifetime spent working toward achieving financial stability in retirement, the last thing investors want to do is to let their portfolio get blindsided by a market risk that could have been avoided. Experiencing a significant portfolio loss in the early retirement years (timing risk) is one of the greatest risks to the longevity of a retirement nest egg (shortfall risk). This risk is typically a function of being concentrated in the wrong asset class — any asset class — at the wrong time. Investors don’t need to accept this. By looking at a portfolio through a risk lens, gaining a greater understanding of what drives asset classes in order to achieve true economic diversification, and allowing the questioning of conventional portfolio constraints, investors can gain valuable insight into building a portfolio that minimizes concentration risk and can increase the chances of achieving retirement success.

For the full analysis, click here to read our white paper Engineering a Better Retirement Portfolio.

See more Market Insights from Columbia Management.

*In these examples, the 60/40 will be represented by the S&P 500 Index and the Barclays U.S. Aggregate Bond Index, respectively. We do not include the impact of taxes in these examples because of the variation in rates and likelihood of expected changes to the tax code. However, taxes must be factored into the individual investor’s situation, which can be done easily and will translate into slightly higher withdrawal rates or lower monthly expenditures.

** Correlation measures the extent to which asset classes move together. A low correlation indicates greater independence to respond differently to economic and market drivers, while a high correlation means the asset classes will often react similarly to these forces.

The S&P 500 Index is an unmanaged list of common stocks that includes 500 large companies.

The Barclays U.S. Aggregate Bond Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment-grade bonds are represented. Municipal bonds and Treasury Inflation-Protected Securities are excluded due to tax treatment issues. The index includes Treasury securities, government Agency bonds, mortgage-backed bonds, Corporate bonds and a small amount of foreign bonds traded in the United States.