Retirement Portfolio Durability

urability: toughness, strength, resilience, stability.

Building a tough, strong, resilient, and stable retirement portfolio is, very simply, what every retiree wants. Let's examine in greater depth one of these desired attributes, namely stability. In order to achieve "stability", a client may want to park their retirement portfolio entirely (or largely) in cash. This article may help you help them reconsider.

This study examines the impact of building a progressively more diverse portfolio and the corresponding portfolio behavior over the past 38 years (1970-2007). Portfolio assets included in this analysis were large-cap US equities, small-cap US equities, non-US equities, US intermediate term bonds, cash, real estate, and commodities (see Table 2). The 38-year historical performance of large-cap US equities is represented by the S&P 500 Index, while the performance of small-cap US equities is captured by using the Ibbotson Small Companies Index from 1970-1978, and the Russell 2000 Index from 1979-2007. The performance of non-US equities was represented by the Morgan Stanley Capital International EAFE Index (Europe, Australasia, Far East) Index. U.S. intermediate term bonds were represented by the Ibbotson Intermediate Term Bond Index from 1970-76 and the Lehman Brothers Intermediate Term Bond index from 1977-2007.

The historical performance of cash is represented by 3-month Treasury Bills. The performance of real estate was measured by using the annual returns of the NAREIT Index (annual returns for 1970 and 1971 were regression-based estimates inasmuch as the NAREIT Index (National Association of Real Estate Investment Trusts) did not provide annual returns until 1972). Finally, the historical performance of commodities was measured by the Goldman Sachs Commodities Index (GSCI). As of February 6, 2007, the GSCI is now known as the S&P GSCI Commodity Index.

A retirement withdrawal-mode portfolio was analyzed. A starting balance of $500,000 was assumed, with an initial withdrawal at the end of the first year of 5% of the starting portfolio balance (in this case, $25,000), and an annual increase in the withdrawal of 3% to account for annual inflation. Thus, the second year withdrawal in this analysis was $25,750, the third year withdrawal was $26,523, and so forth.

As shown in Table 1, the first withdrawal-mode portfolio analyzed consisted of 100% cash. The 38-year IRR of the 100% cash portfolio was 7.04% with a standard deviation of return of 3.08%. (The IRR is slightly different from the 38-year average annualized return of 6.27% because the IRR takes into account the annual withdrawals from the portfolio). The worst-case one-year portfolio drawdown (i.e., percentage change in portfolio account value from year-end to year-end) was -13.9%, which occurred in 2007. Notice how much different this figure is from the worst-case one-year return of cash (1.05%). This is a very important point. The worst-case one-year return of 1.05% is based on a buy-and-hold assumption (as are ALL published performance data).

Conversely, the worst-case one-year portfolio drawdown is a measure that takes into account the raw return of the portfolio as well as the withdrawals from the portfolio. This latter measure is the realistic measure to focus on when analyzing retirement portfolios. Finally, the all-cash portfolio lost value (i.e. had a lower account value one-year later) 53% of the time-or 20 out of the 38 years. In those 20 years, the average account value loss was -4.4%.

Adding bonds to cash (in an equally weighted portfolio) improved the IRR to 7.71% with only a slight increase in standard deviation (3.63% vs. 3.08% in the all cash portfolio). However, the worst-case one-year portfolio drawdown was reduced from -13.9% to -3.4%. Moreover, the percentage of years with a loss (i.e., frequency of loss) was cut to 24% and the average annual loss was reduced from -4.4% to -2.0%. These dramatic improvements in the performance of the portfolio were not revealed by standard deviation-in fact, using only standard deviation of return as the measure of portfolio volatility would have completely missed the beneficial impact of adding a second asset to the portfolio. In short, standard deviation may hide more than it reveals.

Next, US large cap equities were added to the portfolio. An equally-weighted three-asset portfolio (cash, bonds, large US equity) had a 38-year IRR of 8.69%, or an improvement of nearly 100 bps over the two-asset portfolio. Standard deviation increased to 6.44%, worst-case portfolio drawdown was -9.4%, but the frequency of loss decreased to 18%. A mixed bag of advantages and disadvantages.

Let's skip to the seven-asset portfolio. This equal-weighted seven-asset portfolio was comprised of cash, bonds, large US equity, small US equity, non-US equity, US Int. term bonds, REITs, and commodities--each asset having a portfolio weighting of 14.3%. The seven-asset portfolio had the highest IRR (11.16%), the third smallest one-year draw-down (-10.2%), the third lowest frequency of loss (21%), and the second smallest average loss (-3.9%). Recall that frequency of loss is a measure of how often the year-end portfolio account value was smaller than the ending balance from the prior year.

Also included in Table 1 are three additional portfolios: a custom-weighted seven-asset portfolio, a 60% large US equity/40 bond portfolio (the classic "moderate allocation" portfolio), and a 40% large US equity/60% bond portfolio (the classic "conservative allocation" portfolio). The custom-weighted seven-asset portfolio generated a nearly optimal blend of return and portfolio stability (as gauged by worst-case portfolio drawdown and frequency of loss). The equal-weighted seven-asset portfolio generated the highest IRR, but with a higher frequency of loss (21% vs. 16% in custom-weighted portfolio). The risk/reward combinations of all 10 portfolios are summarized in Figure 1. Return is measured by IRR, while risk is measured by frequency of loss (or the percentage of time that the portfolio lost value on a year-to-year basis). I'm suggesting that this particular measure of "risk" is much more realistic and useful than standard deviation of return.

Portfolio durability during retirement requires that a variety of assets be included. Customized blends will abound, which is fine. The core message of this study is this: cash alone will not get the job done. Even a conservative allocation two-asset portfolio (40% large US equity/60% bonds) represents a significant improvement over an all cash portfolio as seen by an increase in IRR of 228 bps and a decrease in loss frequency from 53% to 21%. Likewise, an equally weighted cash and bond portfolio produced a dramatic drop in the worst-case portfolio drawdown and in the frequency of loss compared to the all cash portfolio.

There is a lumber metaphor that applies here. A glue laminated wood beam is much stronger than a solid wood beam of the same size precisely because the laminated beam is comprised of layers of wood with differing grain patterns. It is the diversity of the components that gives the "glulam" its strength. In like manner, the strength and durability of a retirement portfolio comes from adding diverse components.

Table 1. Portfolio Progression in a Retirement Withdrawal Portfolio (1970-2007)

Equally-Weighted Assets in Retirement Withdrawal Portfolio   ($500,000 starting balance, 5% withdraw rate, 3% inflation rate of annual withdrawal)	38-Year IRR  (%)   1970-2007	38-Year Standard Deviation of Annual Returns  (%)	Worst-Case One-Year Portfolio Drawdown (%)a   (Year Worst Loss Occurred)	Frequency of Loss   (Percentage of years portfolio lost value as measured by % change in year end-to-year end account balance)	Average Annual % Loss   (In those years with a loss in account value)
One-Asset Portfolio 100% Cash	7.04	3.08	-13.9   (2007)	53%	-4.4
Equal-Weighted Two-Asset Portfolio 50% each: Cash & Bonds	7.71	3.63	-3.4   (2004)	24%	-2.0
Equal-Weighted Three-Asset Portfolio 33% each: Cash, Bonds, Large US Stock	8.69	6.44	-9.4   (1974)	18%	-4.3
Equal-Weighted Four-Asset Portfolio 25%  each: Cash, Bonds, Large US Stock, Small US Stock	9.49	9.33	-14.2   (1974)	24%	-5.3
Equal-Weighted Five-Asset Portfolio 20% each: Cash, Bonds, Lrg US, Sml US, Non-US Stock	9.89	10.34	-16.9   (1974)	21%	-8.0
Equal-Weighted Six-Asset Portfolio 16.7% each: Cash, Bonds, Lrg US, Sml US, Non-US, REIT	10.24	10.58	-18.8   (1974)	16%	-10.0
Equal-Weighted Seven-Asset Portfolio 14.3% each: Cash, Bonds, Lrg US, Sml US, Non-US, REIT, Commodities	11.16	8.60	-10.2   (1974)	21%	-3.9
Custom-Weighted Seven-Asset Portfolio 20% Cash, 40% Bonds, 12% Lrg US, 8% Sml US, 10% Non-US, 5% REIT, 5% Commodities	9.64	5.92	-7.3   (1974)	16%	-2.6
Conservative 40/60 Allocation 40% Large US Stock, 60% Bond	9.32	8.02	-12.2   (1974)	21%	-4.7
Moderate 60/40 Allocation 60% Large US Stock, 40% Bond	9.66	10.66	-18.8   (1974)	26%	-6.6

^a Worst case single year portfolio draw-down is a measure of the percentage change in the ending portfolio value from the end of one year to the end of the next year after considering the annual withdrawal. This measure is dependent on the prior year.

Figure 1. Performance and Loss Resistance in Various Withdrawal Portfolios

1 = 100% Cash
2 = 50% each Bonds, Cash
3 = 33% each Cash, Bonds, Large US Stock
4 = 25% each Cash, Bonds, Large US Stock, Small US Stock
5 = 20% each Cash, Bonds, Large US Stock, Small US Stock, Non-US Stock
6 = 16.7% each Cash, Bonds, Large US Stock, Small US Stock, Non-US Stock, REIT
7 = 14.3% each Cash, Bonds, Large US Stock, Small US Stock, Non-US Stock, REIT, Commodities)
CW = Custom-Weighted 7-Asset Portfolio (12% Large US, 8% Small US, 10% Non-US, 5% REIT, 5% Commodities, 40% Bond, 20% Cash)
60/40 = Moderate Allocation Portfolio (60% Large US Stock, 40% Bond)
40/60 = Conservative Allocation Portfolio (40% Large US Stock, 60% Large stock)

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Craig L. Israelsen, Ph.D., is an Associate Professor at Brigham Young University and Principal at Target Date Analytics, LLP (www.TDBench.com).