Among investors pursuing long-term objectives like retirement, there is an understandable tendency to focus on the accumulation of assets. But as populations around the world age and need to tap into accumulated wealth, there will be a growing interest in sound decumulation practices — a complex investment challenge and the subject of a recent research project we conducted.
The path-dependency effect
A decumulation strategy must support regular withdrawals from a portfolio regardless of the performance of the underlying investments. Unless the strategy generates a sufficient return, withdrawals will eventually erode the capital below a desired amount or completely (longevity risk). Even if the return is equal to the withdrawal rate, erosion could occur, as the return replacement process is affected by path dependency (or sequencing risk), which is in turn determined by the interaction between the withdrawals and specific characteristics of the strategy’s realized return (which we will refer to collectively as the portfolio distribution).
Figure 1 illustrates the role of withdrawals in the decumulation challenge. The orange line shows a US$1 million hypothetical portfolio that generates a -10% return and then experiences a withdrawal of 4% of the initial portfolio value (US$40,000). The portfolio would then need to generate a return of more than 16% to get back to the US$1 million starting point, compared to an 11% return for a portfolio with no withdrawals. For comparison, we included an accumulation portfolio (light blue line), in which capital is contributed periodically and portfolio drawdowns are more limited.