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After a newsworthy market loss, clients usually want to know how long it takes to recover from their losses. Let’s answer this question using the market history.
We use our technique that we call ‘aftcast,’ the antonym of ‘forecast.’ Instead of making assumptions about future growth and inflation rates, an aftcast uses the actual market history to show what would have happened in the past without any predictive claims about the future.
The aftcast starts its calculation by picking a specific year in history, say 1900, at the current age of the client. Using the actual historical returns and inflation, it calculates the portfolio value over time.
Once this is done, the calculation moves on to 1901 as the starting year. It repeats these calculations for all available years in its historic database. A complete aftcast includes all starting years with recorded history, which means all years since 1900 for U.S. markets, and since 1919 for Canadian markets in our model. This provides nearly 4,000 annual data points that describe the exact correct sequence of events, correct sequence of returns, correct correlations, and correct volatility of returns in both random (a.k.a. ‘normal’) and extreme (a.k.a. ‘fractal’) regions of the past. When all starting years are calculated and depicted in the aftcast, this bird’s-eye view of all outcomes makes any shortfalls clearly visible.
‘At The Extremes’
One important note about aftcasting is that planning for retirement income should never be about what happens ‘on the average,’ but what happens ‘at the extremes.’ We all know that what happened in 1929, 1938, or any other year is irrelevant. What is important, however, is showing your client the impact of frequency, size, and persistency of extreme events. Only then can we design a more robust plan for this imperfect world. An aftcast gives us the essential details to accomplish that.
Let’s look at an example: Jane, 65, just retired. She has an RRSP portfolio worth $500,000, with an asset mix of 40 per cent equities and 60 per cent fixed income. She needs $15,000 each year from her savings, indexed for inflation. This is an initial withdrawal rate of three per cent, calculated as $15,000 / $500,000 X 100 per cent, a sustainable amount for life. Jane converts her RRSP to a RRIF. For the rest of her life, she will receive the larger of $15,000 (indexed to CPI each year) or the minimum mandatory RRIF withdrawal amount.
Soon after this planning, Jane’s portfolio loses 15 per cent, it is now worth $425,000. Jane asks, ‘When will I see my portfolio back at $500,000, its pre-crash value?’
Figure 1 displays her aftcast using the Canadian market index. Each gray line on this graph reflects the actual market history. The blue line is the median line, where half of the portfolio values are higher and half are lower for each age. The red line is the bottom decile (bottom 10 per cent) of all portfolio values for each age; we call this the ‘unlucky’ line. The green line is the top decile (top 10 per cent) of all portfolio values for each age; this is the ‘lucky’ line.
Figure 1: Recovery Time, Aftcast for Jane
We see on this graph that if Jane is lucky (the green line), she would see her portfolio value reach the original $500,000 after about 1.8 years (about 22 months). A fast recovery like this is called a ‘V’ shaped recovery.
The median portfolio, the blue line, comes close to, but never reaches that $500,000 mark ever again. Jane will likely have a lifelong income, but the chances are more than 50 per cent that she will never see an account balance of $500,000.
Previous Peak
We ran a multitude of similar scenarios and summarized results in a single chart depicted in Figure 2. As input, all you need is the percentage of loss from the previous peak and the type of the portfolio; accumulation or distribution. The graph tells how long it takes for the median portfolio to recover.
Let’s use an example to demonstrate how to use this chart: Jeff has a balanced portfolio of $1 million. He does not add any money to it, nor does he need any income from it. So, the accumulation rate is zero per cent. The accumulation rate is defined as the dollar amount of annual additions to the portfolio expressed as a percentage of the dollar amount of the current portfolio value. After an unfortunate market loss, his portfolio is down 22 per cent. The question is: When can Jeff expect to see his portfolio back at the $1 million mark?
Answer: In Figure 2, draw a vertical line (the dashed line on the chart) starting at the 22 per cent initial portfolio loss on the horizontal axis. Continue this line until it reaches the zero per cent accumulation curve. From this point, draw a horizontal line towards the left axis and read the number: about 4.2 years. This is historically how long it took themedian portfolio to reach its pre-loss value.
Figure 2: Estimating the Time it takes to reach the Pre-loss Median Portfolio Value
Now, you might wonder what if this loss is followed by a ‘V’ shaped recovery (lucky outcome) or worse, a multi-year downturn (unlucky outcome). Here is a rule of thumb that should cover the vast majority of scenarios: To estimate the lucky outcome, divide the median by three. To estimate the unlucky outcome, multiply the median by 2.5.
In Jeff’s example, the median recovery time was 4.2 years. If he is lucky and this loss happens to be followed by a ‘V’ shaped recovery, he will see his portfolio back to $1 million in 1.4 years, calculated as 4.2/3. On the other hand, if he is unlucky, that day may not come until after 10.5 years, calculated as 4.2 x 2.5. This assumes that Jeff stays invested throughout this time period and does not bail out.
Asset Mix
What about the impact of asset mix? When fractal events happen ‒ as opposed to ‘normal’ market fluctuations ‒ the asset mix has a large impact on the size of the loss, but not as much impact on the recovery time. If the portfolio is heavy in equities, then it loses more, but it also can recover faster. The main risk is the staying power of the client, which is easier to manage in a ‘V’ type recovery. In Figure 2, we used a 40/60 asset mix for decumulation and 70/30 for accumulation portfolios. If your asset allocation is somewhat different than this, plus or minus 20 per cent, it will still give you a good approximation.
Here is one important observation in Figure 2: The line that is labeled ‘Decumulation 3 per cent (RRIF)’ means that the client withdraws the larger of three per cent of the initial portfolio value (indexed to CPI) or the minimum mandatory RRIF withdrawal amount.
Notice that, after a loss of 10 per cent, the portfolio’s median value needs 20 years to reach its pre-loss value. In practice, this means ‘never.’ In these scenarios, you will have an asset value that generally declines year after year with little or no hope of ever seeing its former peak.
You need to keep an eye on distribution portfolios where the loss from its peak is 10 per cent or larger. If this money is required for essential and/or basic expenses, then the sustainable choice going forward is guaranteed income. This can be achieved either through life annuities or segregated funds that offer guaranteed income for life.
Jim C. Otar (B.A.Sc., M. Eng.)
is a retired engineer and financial planner. He is the founder of www.retirementoptimizer.com. This article includes excerpts from his recent book and CE course, ‘Advanced Retirement Income Planning.’