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SWiVal: A New Idea for Stretching Retirement Savings

Most people who calculate how long their retirement savings will last consider two factors: the rate at which they plan to spend money in their retirement account, and the return they expect on whatever money remains in the plan. What they overlook, says Moshe Milevsky, a finance professor at York University's Schulich School of Business in Toronto, are the other major determinants of nest egg longevity: the sequence and volatility, not just the magnitude, of investment returns. At the Forum Milevsky introduces a collar strategy that he calls "SWiVal" for Stable Withdrawal Value.

Milevsky demonstrates that the volatility of returns can have a big impact on how much an investment account grows over time. Suppose, for example, that one investor earns 10% per year on an investment account for two consecutive years, while the other loses 15% in the first year and earns 35% in the second year. For both, the arithmetic mean is the same: 10% per year. However, the arithmetic mean is a poor way to measure long-term investment returns because it ignores the impact of volatility on a total return. That's why multi-year total return figures for mutual funds and other investment accounts rely on geometric mean calculations. In this example, for instance, the first account enjoys a two-year total return of 21%, while the second, more volatile account generates a total return of only 14.75%. In fact, Milevsky says, the greater volatility in an investment account, the lower the geometric mean.

Milevsky also notes that the returns generated by an investment portfolio in the first decade of a person's retirement play a major role in determining how long that person's retirement portfolio will last. Good early returns greatly increase the number of years the portfolio will last, while poor returns greatly diminish its lifespan. Returns in subsequent decades don't have nearly the same impact. The point is easily illustrated by an extreme example: a portfolio that experiences a 100% loss in the first decade has no opportunity grow in the second.

The implications of all this are two-fold. First, the impact of volatility on long-term returns suggests that investors have an incentive to prefer assets, like Stable Value , that produce relatively stable results over those that fluctuate wildly. Second, the impact of the return sequence on long-term results suggests that investors could protect themselves from financial ruin-the complete depletion of their retirement savings prior to death-by hedging their portfolios in those important first years using financial derivatives. The basic strategy would involve purchasing a so-called "zero-cost collar" on the retiree's investment portfolio. The collar would establish a floor on portfolio losses in exchange for sacrificing some of the potential upside if the portfolio performed especially well.

In the financial markets, a zero-cost collar is created by purchasing a put option giving the owner the right to sell an underlying security at a specified price, while simultaneously selling a call option giving the buyer of the option the right to purchase the underlying security at a specified price. Properly structured, the cost to purchase the put option is exactly offset by the price received for selling the call option. Once in place, a collar protects the investor from wild swings in the value of the underlying security. If the underlying security falls dramatically in price once the collar is in place, the put option assures that the investor who bought the collar will still be able to sell the security for a good price. Conversely, if the underlying security rises in value, the call option will cap the profit that the collar buyer would earn.

There are no put or call options specifically designed for diversified individual retirement portfolios right now. Milevsky says he only came up with his idea recently. Although, in theory, it wouldn't be difficult to cobble one together using index options. Nonetheless, the logic of his concept seems unassailable. Using a Monte Carlo simulation, Milevsky calculates how long the investment portfolio of a 65-year-old woman would last under a wide variety of conditions, both with and without a collar. Assuming a 100% equity portfolio and relatively modest withdrawal rate, the woman faced an 11% chance of outliving her portfolio without a collar, but only a 5% chance with a collar. Assuming a moderate withdrawal rate, using a collar reduced her chances of financial ruin to 13% from 20%. Assuming an aggressive withdrawal rate, a collar reduced her chances to 24% from 29%.

Milevsky cautions that his SWiVal collar strategy would not be a panacea. "Just because the probability of ruin is diminished, there is no free lunch," he cautions. "You may be giving up upside, and your heirs may not appreciate you minimizing the probability of ruin." Still, he says, the idea demonstrates that there is still plenty of room for financial services providers to create innovative new products for the retirement plan market.

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