The Smart Take:
We continue on with the series by discussing a lesser known type of risk called bad-timing risk. What happens when you retire into a bad period in the market? How can a few years of negative returns affect the outcome of your retirement?
Prefer to read? See below for the transcript of the show.
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Introduction: 00:03 Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions and get educated about the financial world. It’s time to Retire Smarter.
Walter Storholt: 00:15 It’s another edition of the Retire Smarter podcast, Walter Storeholt here with you. Thanks so much for taking some time to join us for another episode. I’m joined as always by Kevin Kroskey, President and a Wealth Advisor at
Walter Storholt: 00:26 True Wealth Design serving you in Northeast Ohio with offices in Akron and Canfield. They’ve got a fantastic team at True Wealth Design. If you want to find out more about them, just go to TrueWealthDesign.com you can subscribe to the podcast, learn lots of great information about the team, listen to past episodes, all sorts of good stuff there on the website as well. And it’s actually important for you to know that because this is part two of a series that we’re currently doing. So I invite you to go back to one episode. You could probably go ahead and listen to this one without having listened to the first one, but you’ll want to hear the entire series eventually. So go back to episode 16 right before this one and make sure you listen to part one of our retirement income planning series. Kevin, thanks for taking the time to join us once again and I’ll walk through today’s a topic. I hope you’re doing well.
Kevin Kroskey: 01:11 I am Walter. I hope the same for you. I’m excited to talk about retirement income today.
Walter Storholt: 01:15 Well that’s a really important topic for anybody that is maybe excited about their retirement future. And through this series, we’re pointing out some of the things that you want to keep in mind when it comes to retirement income. Some of the risks that we face, some of the issues that folks will wonder a little bit about and how they’re going to successfully plan for their retirement. And we talked on part one, Kevin, just a little bit about why creating a retirement income plan is so essential. We use that as sort of a building block episode for this series. But today we’re going to dive into talking about a particular type of risk, something that you’ve coined bad timing risk. What do we need to know about bad timing risk?
Kevin Kroskey: 01:55 Sure. So just to back out for a real quick second and just provide this framework. So in the past episode, we did talk about this retirement income framework where the different strategies that would come out of your financial plan and when you’re deciding how to implement and go ahead and create income on the two categories of whether it’s going to be more in an investment or probability-based or more of an insurance or guaranteed based and while guarantees sound great, they’re pretty expensive, which is something that we’ll delve into in a future episode in the series. And we started talking about that framework and so if we’re going to go ahead and say, on one hand, Hey, these guarantees are pretty expensive, if we’re going to go down that path, we at least need to be mindful of it. If we go down the other path, the albeit less certain path non-guaranteed more probability-based path, then we encounter this major, major risk and have to be mindful of it.
Kevin Kroskey: 02:49 And I call it bad timing risk. If you look in the academic literature that really smart people call it “return sequence risk.” And in effect really what it is, it’s just retiring into a bad period of time. And when you think back over the recent past, you know, we had certainly had bad periods of time in late 2007, 2008, early 2009, it was quite a bad period of time. Go back a little bit before then. When the tech bubble burst, say 2000 through 2002 also really bad series of returns there. And when you’re looking at retirement and potentially 30 plus years in retirement, if you have really negative returns right at the outset of retirement, let’s say for the first two or three years while you still have, you know, 27, 28 more years to go ahead and provide that income stream for. So, it’s kind of this retirement red zone call, whatever you want.
Kevin Kroskey: 03:44 But basically the last few years leading into the last few years of work and the first several years of retirement, I really do hold a lot of the call it crystal ball forecasts, if you will, as to how successful or not your retirement going to be. So because nobody has a crystal ball, we have to plan for this risk. So we’re going to go through in today’s episode and talk about that and talk about a few key concepts to understand. We’re going to try to not get too far into the weeds on the numbers in the math. If you go to the website, we’ll link to an article that I wrote a year or two ago on the same topic that we’ll actually have the math there. So we’ll try to keep this a little bit of a higher level
Walter Storholt: 04:29 From having gotten a sneak peek at the article that you wrote here and the graphic. It’s powerful to see the graphic and I know that you’re going to do a great job of putting this into an audio version for those who don’t have the ability to maybe click and look at it as we speak, Kevin. But it is really powerful to see the illustration that you’re going to take through for us today. This is something I’ve certainly heard talked about before, but I don’t know if I’ve ever really seen the math done to just show how dramatic a difference it is when you run into this risk, this risk of bad timing. So I’m looking forward to your, to your examples and illustrations of just, you know how, boy, if you have a little bit of bad luck here, you’re not have having a plan in place for it. You’re in trouble.
Kevin Kroskey: 05:10 A few of these concepts that we need to understand. The first one is just understanding the difference between average returns in compound returns. So the example that’s on the website has an average return of 6.8% and if we could get 6.8% each and every year throughout retirement without any ups or downs, then that would be quite nice. You can go ahead and plan with a much more deterministic future or you know how much money is coming in. There’s not going to be the 2008s or the tech bubbles that are bursting and making your account balance go down. But investments don’t really work like that. I heard somebody wants to describe this volatility as a wiggly factor. And if you have, you know, money down at the bank, the interest rates are going to move and they’re going to wiggle a little bit. If you have money and say US government bonds of maybe, you know, 5, 10 years or corporate bonds, they’re going to wiggle a little bit more.
Kevin Kroskey: 06:10 And if you put money into stocks, it’s going to wiggle a whole heck of a lot over time. So you’re always going to have this wiggling or volatility and you’re never going to get the average return. You never going to get that same return each and every year. So the math goes like this. I’ll use a simple example. You know, suppose you have $100 in year one and you’ll lose half of that money. Walter, I’m a put you on the spot here. $100 you start with it, you lose half the money we have after that your first year.
Walter Storholt: 06:41 This may get dicey as we go, but I can do that first one. We’ve got $50 left.
Kevin Kroskey: 06:45 All right. So we have $50 left, and so we lost half our money. So we had a 50% decline in our dollars. So negative 50% return.
Walter Storholt: 06:56 That’s pretty rough. I don’t like that.
Kevin Kroskey: 06:57 Yeah, put a couple of more zeros behind that, $100 and then you really won’t like it. So you have a minus 50% return. What return do we need to get back and breakeven?
Walter Storholt: 07:12 The simpleton would say, well, not simpleton, but 50% would take us back. But that would be incorrect, right? It’s a hundred I’ve played this game once before.
Kevin Kroskey: 07:19 Sure, sure. Yeah, you can play it well, Walter. So we need to double our money. So, it’s kind of the uneven math, if you will, of compounded returns. You go from a $100 down to $50 you’ll lose half of your money. You go from $50 to $100 you need a 100% return. So when you look at that, all you did and say that occurred over two years, you know, year one minus 50% year two positive, 100% you’re back at zero.
Kevin Kroskey: 07:48 So the compound of return would be zero the average return, let’s just do some again. I said I was going to be a light on math. This is going to be it, we have minus 50% and we have a positive 100% so to get the average over two years, we need to add those together. We get 50% you know, minus 50% plus 100% percent. With a 50% return and well, and then you divided by two, right? So our average return over that two year period is 25% our compounded return is 0%. So one of the things I, again, financial humor, difficult particularly for me, but one of the things I like to say is we eat compounded returns. You’re not going to go down to the grocery store or go out to dinner and spend your average returns.
Kevin Kroskey: 08:35 You’re only going to be able to eat your compounded return. And so that example is, you know, there’s a lot of wiggle there. So it has a pretty extreme example. Most people don’t have that kind of wiggle when they’re going into retirement. You know, they’re having more of a stock and bond mix, maybe some cash, what have you. But whenever you take examples to the extreme, it really helps to illustrate the point. So that’s a big difference between average and compounded returns. Now one other concept that’s really important to understand when we talk about this bad timing risk is this. So suppose when we start out investing and say that we just hit the lottery. So, one you shouldn’t be playing the lottery unless if you’re doing it, just do it for entertainment value only, not visit some sort of retirement strategy.
Kevin Kroskey: 09:21 But I suspect to anybody listening to this already knows that. So if he did hit some lottery or you inherited some money from, you know, a distant relative and you have $1 million and I’m going to use that number just because it makes, you know, it’s a nice round number. So if I do have to do any math on the spot and makes it a little bit easier for me. So you have that million dollars in you invest it and you invest it over, say we go five years down the road and then we look back over the prior five years and see what happened. And you know, maybe in year one we had a really good year, year two, maybe another good year. Year three was a really negative year. Not good to be an investor. We saw our money go down quite a bit, year four, so on and so forth. So, it doesn’t really matter what the numbers were, it’s just, you know, the point being that the returns are going to vary over time.
Kevin Kroskey: 10:15 They’re going to wiggle. And so after the end of year five, we end up with some value. So when we’re talking about bad timing, all of that I’m going to do here. We’re going to have the exact same return sequence. So rather than going say the return for year one, two, three, four, five, let’s just flip it. Let’s count back from say, Hey in this example to illustrate this point about return sequence risk or bad timing risk, we’re just going to go backward and say the return that we got in year five is really going to be the return that we had in year one in this other sequence and the return that you’re your is going to be the return we got near two, so on and so forth. So we’re just going to count backward. Same returns, just a different order of returns. So again, in this example we start off with $1 million and then we look at both of those sequences, both of those scenarios and how much money is left at the end of five years.
Kevin Kroskey: 11:12 Again, scenario one returns, one, two, three, four, five. Scenario two returns and backward were years five, four, three, two, one. And what you find, Walter kind of put you on the spot for this.
Walter Storholt: 11:23 Please do. I may or may not have pulled up the calculator, so I’m ready.
Kevin Kroskey: 11:28 All right. So, I’m just trying to think how I can ask this question in an intelligent fashion. What could you tell me about the dollar difference, if any at the end of year five from those two sequences?
Walter Storholt: 11:45 My reaction would be that they should be the same is how it seems that this should go. Like the logical first blush thought.
Walter Storholt: 11:54 Is that if the returns are the same, it shouldn’t matter in what year they happen because it’s all starting at the same point. It’s all going up and down just at different times to different levels. And so therefore we should end up at the same amount at the end of five years.
Kevin Kroskey: 12:09 You are exactly, exactly correct. Good job Walter. Let’s get applause in the background. So what different though.
Kevin Kroskey: 12:19 Most of us don’t have a wealthy uncle that we inherit a large amount of money from or hit the lottery and just kind of let it ride forever. No, more typically we’re working, we’re saving, we’re putting money into our 401k every paycheck and maybe we’re saving some additional in a Roth IRA or in a joint or trust account. And you’re putting this money in as you’re climbing the ladder and you know you’re paying off the mortgage and cashflow frees up and you’re saving more and saving more. And so you’re putting all this money in. And then when you get into retirement, obviously you no more paycheck and you have to kind of recreate it. Thus the whole series of retirement income that we’re going through. So whenever you introduce those cash flows, whether it’s cash coming in or cash coming out of the portfolio, and you vary the sequence as we just did, even though the returns and the percentages are going to be the same, the percentage of the returns and you know, some volatility, the wiggle factor is going to be the same.
Kevin Kroskey: 13:18 What’s going to vary and very potentially quite substantially are the dollar differences. And this is where, again, it really matters in the last few years of work leading up to retirement and particularly in the first handful of years or so in retirement. And if you go to the site and look at the example, what you’re going to find is it’s going to have $1 million starting balance and basically pulling out about 5% or $50,000 a year to live on. And it goes out for 25 years. So over this 25 year time period, the same thing’s going to happen is what we did in our simplified example earlier, but it’s going to be 25 years of returns and then a sequence A and sequence B and all they are the reverse of B, just the reverse of A. So the return, the average return is 6.8%. The compound return is 6%.
Kevin Kroskey: 14:11 If you look at the whole distribution of returns, on average, about two-thirds of the years are positive, which is very much akin to the stock market. It’s on average up about every two out of three years and the wiggle factor or something, mathematically we call on a standard deviation is about 12% or 13%. So the reason why I’m saying this is its representative of an actual investment portfolio that someone might have, you know, going into retirement. So when I look at this table and see how the returns can go and sequence a, it starts out with minus 15% in year one. So the value goes down from about a million to 807,000 after the $50,000 is taken out and the 15% decline happens then minus 4% so you still negative, but closer to zero minus 10% and it goes through, I’m not going to go through every year, but ultimately what you find is even though sequence a has an average return of 6.8% and a compound of return of 6%, they’re out of money after year
Kevin Kroskey: 15:22 19, come year 20 at this time, suppose that they’re 60 years old or 65 years old, you know, they’re only 80 or 85. You know, there’s definitely still some living likely to be left and they’re completely out of money. And of course, this assumes that they didn’t make any changes, but they’re completely out of money starting with $1 million pulling out about 5% per year after year 19 year 20 you are dead broke. So pun intended, I suppose now if all we do is reverse the order of those returns, so they start off in return sequence B starts off quite positive, 22% up, 8% up, 30% up. They don’t actually have a negative return until year nine. So the lucky if you will. So I would say the first one got unlucky. The second one got quite lucky. And what you find there is even though they start with the same million dollars and pull out the same $50,000 per year, rather than being dead broke and year 20 at the end of year 25 they actually have $2.4 million. Same returns.
Walter Storholt: 16:25 Wow.
Kevin Kroskey: 16:29 Different order, same compounded return, same average return, same standard deviation, incredibly, incredibly different results. So that’s bad timing. Are you going to get lucky or are you going to get unlucky?
Walter Storholt: 16:42 And obviously the fact that they’re taking money out of these accounts plays a big role, a big factor in this because now you’re hurting your chances of recovery when you have those early down years even more. Because theoretically you’re not just drawing the same percentage out of your portfolio as the value goes down and you continue to draw a $50,000 just because your portfolio went down a percentage doesn’t mean your lifestyle is going down a percentage. And so you knew, you’re now drawing what was 5%, you’re now drawing out 6% 7% 8% of your portfolio, and then that just dramatically starts to increase, right?
Kevin Kroskey: 17:17 Yeah, completely. So a lot of people have heard of something called dollar-cost averaging, basically like putting money through your payroll deduction in your 401k and then it just keeps going in, you know, every two weeks, twice a month, whatever the frequency may be. And over time, you know, with that consistent you’re going to buy some, you know, when the stock market is expensive, you’re going to buy some, when the stock market is not expensive but over time kind of average and, and it compounds and you create wealth. Well the same thing can happen in reverse. And so you could have reverse dollar-cost averaging effect when you’re in retirement. And that’s exactly what you just described, Walter. I’ll describe it in another way with a short story. So, in late 2008 and you know, most people listening to this will remember what happened in 2008, but when Lehman Brothers were allowed to fail in September, things got really bad.
Kevin Kroskey: 18:12 The market had already been bad. Or then a couple of different investment banks that blew up earlier in the year. And the returns actually started going down in the market in 2007 and sped up in 2008 and I met a guy named Steve, change his name for confidence purposes, but met him in October 2008 and I would say that scared was a bit of an understatement. So, Steve had retired earlier that summer in 2008 after having about 30 years in for Goodyear, which is a large employer in our area. And he was only 54 at the time. He turned 55 and October, 2008 and what Steve did was not only did he retire, but he took his pension is basically his guaranteed income and converted that into a lump sum and rolled it over into his IRA and invested it. He did this with the help of, I’ll use the term advisor very loosely here, but an advisor that he was working with and went ahead and invested that money in about 80% in stocks, which was generally comprised of individual stocks, which is also a big no, no in about 20% in bonds and cash and really had no financial plan.
Kevin Kroskey: 19:26 It was more of the investment plan I would say is kind of throwing darts at the dartboard and trying to hope that you hit it and there are all kinds of issues even beyond that with what was going on. But what happened to Steve was literally from the time that he retired, rolled over his pension and converted that guaranteed income into a nice sizeable amount of money in his IRA. He lost about 60% of those dollars. He’s only 54 years old. His mom just passed away last year and she was in her nineties so here’s somebody that retired in their mid-fifties had, you know, at least eight years until Social Security was going to start and he lost about 60% of his money. Scared absolutely was an understatement. He told me he was having difficulty sleeping at night. He was thinking about going back to work.
Kevin Kroskey: 20:22 He was pretty much ready to capitulate and you know, he thought he was going to lose everything and it was going to go to zero. And I mean I just was only going to let that happen to him. We started working together after this had already happened and so I was tasked with, I’m going to help you pick up the pieces and you know, you took the risk and boy did you have some bad timing risk. And unfortunately, again, we couldn’t go back and you know, redo the prior months and actually put a plan in place. Frankly, I would not have had him take his monthly pension in a lump sum form. The math didn’t make sense at the time for the Goodyear pension plan, but that was all water under the bridge. It was just like, what are we going to do going forward? And so we worked through it, but anytime I talk about this bad timing risk, this is the example that I give.
Kevin Kroskey: 21:11 I talk about Steve and he knows that I talk about him and he’s like, yes, tell people, because I don’t want them going through what I went through because it was not pleasant and Steve is fine today. You know, we certainly had to cut back a little bit. We looked at, you know, things that we could do as far as maybe even utilizing reverse mortgage and some other things, but ultimately he’s fine and we did not pull back the risk. I told him, I look, you know, you took the risk. You didn’t necessarily take it smartly with the quote-unquote advice from this other person, but you took the risk. We’re going to stick around for the return now and you hear quite sizable returns once the market did come back. But then over time we went ahead and kind of reduced the risk in his portfolio as his plan became, you know, more well-funded.
Kevin Kroskey: 21:55 He actually had a financial plan and as the market continued to do better, we just said, okay, you know, Hey, we took the risk. We don’t necessarily want to go through that again. Let’s start reducing our risk and just having a little bit more of a sleep at night factor. So that’s about as bad of a bad timing risk as you can get. When you’re, you know, mid-fifties you had no guaranteed income until Social Security starts, at least, you know, eight years later, potentially 40 years ahead of you, and you just lost 60% of your money. You know, that shouldn’t happen to anybody. Frankly. I mean, that guy that was giving him advice probably should’ve gotten sued, but that’s what you have to plan for. You don’t know, you know, if a 2008 is around the corner or if you know, some planes are going to fly into a building and kind of, you know, burst the tech bubble and start going down, you know, God forbid that stuff happens again.
Kevin Kroskey: 22:41 But these big financial storms do happen from time to time. Historically tend to be a once in a generation sort of thing. Kind of got to in the more recent past, hopefully we don’t see one anytime soon. But nonetheless, even if it’s not that severe, even if you have a period of, of very low and muted returns and some of those are negative in the early years of retirement, it’s a dramatically different financial plan then if you have a real tailwind at your back.
Walter Storholt: 23:08 Yeah. And your illustration just to kind of support that, for those who aren’t seeing the chart or are looking at the numbers at this moment, do encourage you to go look at that later. I mean the negative years are -15%, -4%, -10% the first three years followed by three positive years. In that example 8%, 12% and 10% all sounds very plausible, could certainly see that it’s not an unreasonable scenario to think about. And already in the portfolio after those six years is down almost $400,000 from the $1,000,000 that you started with and then by year 20 you are out of money as the whims to go up and
Walter Storholt: 23:46 Down compared to just having some good timing on the front end. So I guess it comes down to things we can control and things we can’t control Kevin, but we can’t control the whims of the stock market. So how do you put together a plan that can avoid things like bad timing? Because we kind of shrug our shoulders at most of the things in life where we experience bad timing as well. There was nothing you could do about it.
Kevin Kroskey: 24:07 Yeah. You know, Walter, that is a great question and that’s why we’re in this retirement income series, but because we’re going to be talking more about it,
Walter Storholt: 24:16 You can’t give them away all the goodies yet. Is that what you’re saying?
Kevin Kroskey: 24:18 That’s right. But you know, if you’ve been listening to some of the prior episodes, this is something that you need to go through. You have to start with, you know, something that Steve didn’t have yet to start with the financial plan and it has to be reflective of your lifestyle and the goals that you have for it. And then you start working down through the different income sources that you have, Social Security, pension and making smart claiming decisions there. And then you really start stress testing. This is where you get into the investments and we’re not talking about throwing a dart at the dartboard, but we’re really talking about stress testing the plan, making sure that your plan can, whether you know any sort of storm and then also looking at it relative to the goals.
Kevin Kroskey: 24:57 You know, is it something that is more of a need? Is it something that is more of a kind of a discretionary goal that Hey, if you really did have to cut back, it may not be desirable, but it’s not like you’re going to have to go back to work sort of thing. All those things really are parts and pieces of a well-constructed retirement plan that then has to be matched with a very good investment plan. So we really believe in a goals-based investing approach. We’ll talk about it some more in the next episodes, but if anybody’s listening to this and kind of on the cusp of retirement or you know, Hey, we’re in this you know, quite an extended series of positive returns in the market. I mean, 2018 was slightly negative, but we’ve had quite a long run and are back in the markets, bounced back up quite strongly this year.
Kevin Kroskey: 25:44 So I’m not going to say that anybody retiring today is going to be in one of these bad timing events, but you know, just mathematically we’re probably closer to it than not. So, if anybody’s concerned about that, all you have to do is go to the website. We have a button there and says “are we right for you” and we would be happy to speak with you. We do a 15-minute calls with one of our Certified Financial Planners, to answer some questions, see how we can help. And see if it makes sense to get together in person and talk some more.
Walter Storholt: 26:14 That’s TrueWealthDesign.com. Also where you can listen to past episodes of the podcast here on Retire Smarter. You can subscribe using your favorite podcasting app as well. Lots of great information and be sure to go back and listen to the first part of this series as well. If you haven’t heard it yet as we’re going to be walking you through a couple of different things to be thinking about when it comes to retirement income and that very important aspect of this whole process, all the ins and outs and things that you need to know. We’re setting the stage for it each episode and have another great topic on the docket for next week as well, so be sure to come and join us for that one as we’ll look forward to another episode here of Retire Smarter. Kevin, thanks so much for the help and we’ll see you again soon.
Kevin Kroskey: 26:54 Sounds good, Walter. Thank you.
Walter Storholt: 26:55 Alright, that’s Kevin Kroskey. Walter Storeholt here. Thank you for taking the time out to join us. If you have any questions at all for Kevin TrueWealthDesign.com your place to go or give a call to the team at (855) TWD-PLAN, (855) 893-7526 is the number. Thanks for joining us and we’ll talk to you next time on Retire Smarter.
Disclaimer: 27:23 The information provided is for informational purposes only and does not constitute investment, tax or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance referenced is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.