Sensitivity to Loss
What Is "Sensitivity to Loss"?
Before retirement we add to savings, but during retirement we withdraw from savings. These withdrawals combined with negative investment experience are a bad combination. This is because when favorable experience does arrive, it may apply to assets which have been reduced by withdrawals, as well as by negative returns. In other words, the favorable experience needs to be that much greater to make up for the poor returns.
For example, a pre-retirement saver with $100 who losses 20% in one year can make up that $20 loss with a 25% gain the next year.
$100 - $20 (20% loss) = $80
$80 + $20 (25% gain) = $100
But a retiree with $100 who withdrew $5 for living expenses, after the 20% loss, would need a 27% gain to make up the $20 lost.
$100 - $20 (20% loss) -$5 (living expenses) = $75.
$75 + $20 (27% gain) = $95
That difference may look small but it is not. In our example, the extra 2% in return required for the retiree to make up for the loss is more than 30% of one year's retirement income.
What Causes It?
A retirement income plan that might have to last for 30 or more years, and cover increases for inflation, is especially vulnerable to investment losses. This is because each year that goes by, more savings are withdrawn to meet expenses, leaves a smaller amount available for investment to make up for past losses.
Consider, for example, how losses could affect a hypothetical couple, John and Kathy, who decided to retire in 1971, then both age 62. They wanted their income to last for 35 years because of the odds at least one of them would live that long.
John and Kathy planned to withdraw $15,000 a year from their savings of $300,000, (5% of their savings). In addition, they planned to increase their annual withdrawals by 3% each year to allow for inflation during their retirement. So, in year two their withdrawal would be 103% of $15,000, or $15,450, etc.
Here's what happened:
Sensitivity to Loss - Asset Balances
(after withdrawals & earnings)
The two lines on the graph show the assets remaining at the end of each year, after taking into account withdrawals and earnings experience.
Green Line: If John and Kathy's assets could earn a net return of 7.7% each year (the effective annual return of the S&P 500 Composite Stock Index over the last 35 years), the green line above shows this plan would work well. These earnings would provide the planned income amount each year without even dipping into their $300,000 starting balance before the end of the 35 years.
Red Line: The red line shows what happens if the annual net returns on John and Kathy's assets exactly matched the actual annual returns of the S&P 500 Composite Stock Index from 1971 through 2005. During that time, the annual return of the Index was volatile and included many years of loss as well as many years of gain. The outcome here, for Kathy and John, is much worse, even though both the red line and the green line have the same effective annual return of 7.7%! The early losses and withdrawals, which caused the red line to decrease so much in the early years, could not be made up later, and John and Kathy's assets are depleted after just 22 years.
Their sensitivity to loss, in short, meant that John and Kathy ran out of retirement assets many years before they had expected and while they still needed the income.
Note: Information provided in the Planning Retirement Income tab is representative of the views of ELM Income Group® and not necessarily those of any member of the Principal Financial Group®.
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