7% Return Dilemma – Flaw of Averages

Retirement planning is done conceptually. Hypotheticals, round numbers and easy-to-understand illustrations are the norm.
This works fairly well to obtain a general idea about your retirement direction and is better than no plan at all. But more often than not, one of the most important aspects of distribution planning is overlooked during the process. Hence…the “7% Return Dilemma”.

The 7% return dilemma works like this – “If I can just average a 7% return on my investments during retirement, I’ll be alright.” Rate of return, rate of return, rate of return. But just as the enclosed picture depicts a 3 foot average deep river, averages don’t always work out. Have you seen the numerous case examples showing 2 retirement plans, both averaging a 7% return? The only difference is one plan’s income lasts 6 years longer than the other. Why? ORDER OF RETURNS (AKA – The Flaw of Averages).

“One of the more compelling aspects of investing is the math of gains and losses. Very simply, a 50% gain does not allow a portfolio to recover from a 50% loss. In fact, a 100% gain is required to restore a 50% loss.” – Dr. Craig Israelsen, “The Math of Gains and Losses.”, 2009

CLICK HERE for a copy of Dr. Israelsen’s full report.

A very successful financial planner I consult, Mike Reese, said it well: “You can achieve your target rate of return and still fail miserably with your planning. In this story, Joe had a big “MAYBE” with his retirement planning. ‘Maybe’ he would succeed and ‘maybe’ he would fail; it all depended on a variable he didn’t control – the market.”

 – CLICK HERE for “Losses & Recovery”Slide, used by Mike & several top producers

To study more on the topic, check out The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty, by Dr. Sam L. Savage, John Wiley & Sons 2009.

 – CLICK HERE to view that book’s website and to learn more.

So the next time you’re putting together a client’s distribution plan (thinking about rate of return, asset allocation and investment diversification) – Do your clients a favor…address the sequence of return risk too. More on this to come soon…but this should get your wheels turning.

Matt
http://www.advisorsadvisor.com

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