Protecting 401k Retirees from the Ravages of Bear Markets

A bear is coming for your client's 401(k).
A bear is coming for your client’s 401(k).

When one compares and contrasts the risks and returns of several investment options, it is usually conducted in a sterile, simplified fashion. Whether comparing mutual funds, ETFs, target date funds or any other type of investment, the typical analysis is performed by 1) picking an arbitrary start date for the initial investment and 2) assuming a buy-and-hold position thereafter. If one is interested solely in the merits of one manager versus the other, this kind of simplified analysis is appropriate as it removes a lot of the “noise” from the equation. But, in the real world, the actual investor is presented with numerous variables that will greatly impact the success or failure of his investment plan.

The first issue is one of timing. When one chooses to make an initial investment can have a huge impact on long-term results. While it might seem obvious that one should “buy low”, it is jarring to see how much of a difference it makes on long-term returns if one were to invest at either the peak or bottom of a market. In the chart below, we graph a collection of 10-year investment results in the S&P 500 index. In each case, a $100,000 investment is made on New Year’s Day and held for a decade. The only variable at play is which New Year’s Day. So, the first line shows the period 1998 to 2007, the second 1999 to 2008, and so on, with the most recent period being 2006 to 2015.

S&P 500 10 year returns graph
Source: Zephyr StyleADVISOR, Swan Global Investments

The results look like a mess – but that’s exactly the point. If someone was fortunate enough to have invested in the most recent ten years, they would have benefitted from the third-longest bull market in U.S. history and seen his assets double. Conversely, someone investing just as the new millennium started would have experienced not one but two huge bear markets in the span of ten years. That unfortunate investor would have truly experienced a “lost decade” and would have lost almost 13% on his investment. One might conclude that an investor’s success or failure depends upon nothing more than luck.

The second real world variable that actual investors need to contend with is withdrawals. This is especially relevant as the baby boomers start to retire and the nest eggs they’ve built up in their IRAs and 401ks are used to fund their retirement. As investors transition from the accumulation to distribution stages of their life cycle, bear markets become much more harmful. Indeed, during the accumulation stage bear markets provide the investor the opportunity to buy the market at a discount. As long as the saver had the fortitude to stick to an investment plan, the bear markets of 2000-02 and 2007-09 were buying opportunities. However, the equation flips if someone is in the distribution stage. Now they are forced to liquidate their holdings at a market low in order to fund their spending, which just digs that hole deeper.

The chart below illustrates the impact of this. Once again we start with a $100,000 investment in the S&P 500, this time with an inception date of January 1st, 1998. The blue line is a simple buy-and-hold strategy through December 31st, 2015, the kind of mountain chart seen throughout our industry. The red line shows the impact of taking $5,000 of withdrawals every year. The good news is our investor was able to make $90,000 worth of withdrawals, but the bad news is his principal is starting to be adversely affected.

S&P 500 With and Without Withdrawls
Source: Zephyr StyleADVISOR, Swan Global Investments

When factoring in real-world variables like timing and withdrawals it is immediately obvious what the biggest detriment to our scenarios are: the two big bear markets of the new millennium. During the dot-com bust of 2000-02, the S&P 500 lost almost 45% of its value. In the financial crisis of 2007-09, the peak-to-trough loss was over 50% in the S&P. At this point, one might argue that someone close to retirement shouldn’t be invested strictly in equities; that the investor near or close to retirement should be more conservatively positioned and would be less susceptible to the problems illustrated with the S&P 500 above.

While I certainly agree that an investor at or near retirement should be more conservatively allocated, the sad reality is many asset allocation plans performed poorly during times of severe market stress. The average target date fund of the vintage 2000-2010 had peak-to-trough losses of over 30% during the financial crisis of 2007-09. In theory these allocations were appropriate for someone near or entering retirement, yet they still lost nearly a third of their value. The two charts below repeat the “timing” and “withdrawals” exercises, using the Morningstar Target Date 2000-2010 category average as the investment. Although more conservatively positioned, we still see worrying amounts of variability and drawdowns.

mstar-TD-with-without-withdrawls
Source: Zephyr StyleADVISOR, Swan Global Investments

Individually, both of these scenarios- timing and withdrawals- are problematic. But what if investors have to contend with both? What if they have the misfortune of investing at the wrong time and are forced to take withdrawals during an unfavorable environment? In this next case study, we combine these two scenarios. Once again we are making a $100,000 investment for a ten-year time span, but varying the start dates by one year. However, this time we are overlaying the impact of taking out $5,000 per year, for a total of $50,000 of withdrawals over the decade. How would that look?

Combination Effects Timing and Withdrawals
Source: Zephyr StyleADVISOR, Swan Global Investments

In the graph above I’ve summarized the results. There are nine ten-year periods in this analysis. After taking out $50,000 in withdrawals, the average value for the S&P 500 is $91,759 after ten years. However, that average masks a wide amount of divergence. The best case scenario is worth $133,958 and the worst case is $37,799. The average for Target Date 2000-10 is similar but the dispersion is less.

The conclusion one can draw from this data is that bear markets are the culprit. Minimizing those large market losses, especially as retirees take withdrawals, has a huge impact. We believe more must be done to address the severe impact that bear markets can have on an investment plan. Today’s retirees don’t have the luxury of time required to simply “ride out” another bear market.

With yields at historic lows and the outlook for equities tepid, it is highly unlikely the standard 60/40 model that has worked so well in the past will produce anything near their historic returns going forward. With unprecedented numbers of American exiting the workforce and their expected lifespan increasing every year, it is a near certainty that the baby boomers will face one or more bear markets during their retirement years. How will they weather the storm?

Marc Odo, CFA, CAIA, CIPM, CFP, is director of investment solutions with Swan Global Investments. Odo is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy.
John Sullivan
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With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.

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