By Dr. Jim Dahle, WCI FounderI had the opportunity to interview Wade Pfau on stage at the 2023 Bogleheads Conference. One of the topics we discussed was how to avoid the Sequence of Returns Risk. There are really four categories of methods to do so.
Sequence of Returns Risk
Sequence of Returns Risk (SORR) is the risk that despite achieving sufficient average investment returns during retirement to sustain a particular withdrawal rate from the portfolio, the retiree still runs out of money because the lousy returns showed up early. It turns out that withdrawing from a portfolio at the same time it is falling in value from market fluctuation is a recipe for retirement disaster. This was the point of the famous Trinity study and the 4% rule. Despite earning average portfolio returns of 7% or 8%, one can only withdraw something like 4% from a portfolio because it's possible that one will have poor returns in the first few years of retirement.
Once you're past those years, if SORR has not shown up, one can safely increase the withdrawal rate significantly. The problem is those early years also overlap with the famous “Go-Go Years” of early retirement when retirees would prefer to spend the most.
4 Methods to Reduce Sequence of Returns Risk
A wise retiree will use one or more methods to minimize SORR. There are four broad categories of methods to do so.
#1 Spend Conservatively
The first method is to simply spend less. This is reflected in the 4% “rule.” Instead of withdrawing 7% or 8%, one must withdraw less. In fact, about half the time, a portfolio of at least 75% stocks would have lasted at least 30 years even with a withdrawal rate of 7%, adjusted for inflation. Of course, the other half of the time, the theoretical 30-year retiree ran out of money before running out of life. By only spending 6% (adjusted up with inflation each year), one reduces that risk by about 20% (down to a 40% rate of failure). By spending 5%, one only runs out of money about 20% of the time. And at 4% or less, the risk is minimal over 30 years, as long as future returns resemble past returns. If one is particularly worried or planning a particularly long retirement, one can reduce that risk further by using a 3.5% or even a 3% withdrawal rate—at least for the first few years to see if SORR shows up. In fact, if you really want to reduce SORR, just be very, very wealthy relative to your spending. There are a surprising number of retired WCIers who seriously only spend 1-2% of their portfolio because they don't want to spend any more.
While just spending less certainly works, other options allow for a more conservative withdrawal rate. The simplest is to work longer. When you work longer, you have more time to save and more time for your assets to grow. You might need a 4% withdrawal rate if you work until age 63. If you work until 66, perhaps 3% of your portfolio would provide the exact same lifestyle. This is similar to just being really wealthy relative to your spending. If you continue to work beyond financial independence, your wealth rapidly increases and if your spending does not increase with it, your needed withdrawal percentage will continue to fall.
You can also reduce how much of your spending needs to be paid for by your portfolio by using some of your portfolio to boost your guaranteed income. Delaying Social Security until 70 increases your monthly benefit amount by 8% per year from age 62 to age 70. That benefit is inflation-protected. Another method is to “buy a pension” using Single Premium Immediate Annuities (SPIAs). While you can no longer buy inflation-indexed SPIAs, the fact that their guaranteed benefit payments for typical retirees are often well over 4% (at the cost of your heirs not receiving any of the principal) allows a retiree to withdraw a smaller percentage of a traditional retirement investment portfolio.
A ladder of TIPS bonds can have a similar effect to an inflation-adjusted SPIA, and it is much more attractive when TIPS offer higher yields than at times of low yields.
Income from a conservatively managed and leveraged real estate portfolio can also be used similarly, although that income perhaps should be discounted somewhat given the additional risk.
More information here:
#2 Spending Flexibility
The second way to reduce SORR—and frankly a much better way to generate retirement spending money from an investment portfolio—is to be flexible about how much you spend. Flexibility of spending is extremely valuable all the time, particularly during retirement years. Research shows that a variable method of retirement withdrawals is significantly superior to blindly withdrawing 4% of the original portfolio adjusted for inflation. This simply means that you spend more when times are good and less when times are bad. This can be formalized with rules (of which there are dozens) or simply “adjusted as you go.” The higher the percentage of your expenses that is variable or, better yet, completely optional—rather than fixed—the easier it is for your portfolio to last throughout retirement. Be aware that if this is the only method you use to deal with SORR, it can require you to be VERY flexible, perhaps spending 50% less for many years if SORR shows up early in your retirement.
#3 Reduce Volatility
Another method of reducing SORR is to reduce the volatility of the portfolio. All else being equal, reduced volatility reduces SORR. Without large swings in portfolio value, there is less risk of severe portfolio size reduction that can occur simultaneously with portfolio withdrawals. This is generally done by adding bonds, CDs, or other lower-volatility assets to the portfolio. This is why most advisors recommend reducing investment risk as you approach retirement years. Target Retirement and other lifecycle funds do this automatically. Unfortunately, these low-volatility assets often generate lower returns, which reduces overall portfolio return and which can also reduce the potential withdrawal rate. In the Trinity Study, a 75/25 (75% stocks, 25% bonds) portfolio survives 5% withdrawals for 30 years 82% of the time. But a 25/75 portfolio only survives 31% of the time.
One method of reducing this phenomenon is to use a “bond tent.” With this technique, the retiree reduces the stock-to-bond ratio a few years before retirement and then actually INCREASES IT AGAIN a few years into retirement. This minimizes the long-term effect of inflation on a portfolio with a large amount of bonds.
However, one can reduce volatility using other methods. These include adding non-correlated but still high-returning assets to the portfolio. An example would be adding international stocks or real estate to a portfolio primarily composed of US stocks.
Inflation-adjusted bonds can help with this phenomenon as well. The main risk with long-term nominal bond investing is that sustained inflation, even for just a few years, can maim the nominal bond portion of your portfolio. Inflation-adjusted bonds such as Treasury Inflation-Protected Securities (TIPS) and Type I Savings Bonds (I Bonds) should theoretically decrease this risk. While the expected returns of these bonds are still low, the effect of inflation should be mitigated. It would be interesting to see a Trinity-style study that used TIPS instead of the corporate bonds used in the initial study. Unfortunately, TIPS haven't yet been around for one 30-year period (invented in 1997), much less multiple.
Another method that helps with this approach is formally known as “time segmentation” but is more commonly known as the “buckets” approach. By having less volatile assets to spend from for a certain period of time (1-10 years typically), volatile assets can be given more time to recover from volatility.
More information here:
The Buckets Strategy for Retirement
Is Now a Good Time to Retire? Here’s What Christine Benz Thinks
#4 Buffer Assets
The final method of reducing SORR is to use buffer assets. A buffer asset is something that does not go down in value that can be spent INSTEAD of using money from the portfolio. The most common buffer asset is cash. Many retirees keep a big pile of cash that allows them to continue normal spending even if both stocks and bonds are down. An amount of cash equal to 1-3 years of spending can be extremely valuable in this regard, and it's often considered when one takes a “bucket” approach. However, holding a lot of cash has a downside: the “cash drag” of the low returns generally available from cash reduces overall portfolio returns. This is the same issue you can have with reducing portfolio volatility by decreasing the aggressiveness of your asset allocation.
Other buffer assets include assets that can be sold. This might include luxury goods such as automobiles, valuable firearms/jewelry/art/collectibles, boats, airplanes, recreational vehicles, investment properties, second homes, and even a primary home. If one owns an $80,000 truck and the market tanks, one can sell that truck, buy a $10,000 truck to use instead, and live off the leftover $70,000. This is one of the wonderful aspects of paying cash for these assets, especially those that are not strictly needed. Instead of actually being a liability (like most consumer goods and property that have storage, maintenance, and insurance costs), it becomes a true asset in an emergency. Obviously, tapping these buffer assets can affect one's quality of life, not dissimilar from simply spending less. Also, the market for luxury goods often tightens during the broad economic downturns that might cause one to consider using these assets for living expenses.
Academics such as Pfau argue instead for the use of debt as a buffer asset. While a private, credit card, or other unsecured loan is an option, the higher interest rates on these types of debt generally make a convincing argument against their use. Thus, borrowing against assets is the more frequently chosen option. This can include a vehicle, boat, or airplane, but most commonly, it will involve a cash value life insurance policy, real property, or your portfolio.
The value of a cash value (usually whole life, although multiple types of universal life policies can also be used) insurance policy can be tapped in several ways. The least costly is a partial surrender of an amount less than or equal to the basis (the amount paid in premiums over the years). Unlike annuities or investments, this “principal” can actually be accessed tax-free before the “earnings.” Another option is to borrow against the policy. While tax-free like all loans, this does cost interest, the terms of which are outlined in the policy and may or may not be favorable compared to other available loans at the time.
With real property, one has the option to do a cash-out refinance; get a Home Equity Line Of Credit (HELOC); or, in the case of your primary home, a reverse mortgage. While these all increase your monthly expense (as the debt now must be serviced) and/or reduce the value of the asset to you and your heirs, this can still be better than selling stocks, real estate, and even bonds in a market downturn.
One can also borrow against their taxable portfolio with a margin loan, a strategy sometimes referred to as “Buy, Borrow, and Die“. The main problems with the strategy are margin calls and potentially high interest rates, but there are times it can make sense, particularly when it allows one to pay a little bit of interest to avoid large amounts of capital gains taxes that would not be paid due to the step-up in basis at death.
While traditional thinking is that tapping assets such as a whole life insurance policy or home equity (especially with a reverse mortgage) should be a last resort, some data suggests it can make for a “more efficient” retirement spending process. These studies all assume that the insurance policy and the valuable house are already owned, of course, and thus it does not argue effectively that one should purchase these items in case they are later needed for this purpose. Often one would be better off simply with the larger portfolio enabled by the avoidance of an “investment” in these low-returning assets.
Another option is for families expecting an inheritance to provide financial support during the downturn. They may prefer this to having the retiree drawing down on a life insurance policy or reverse mortgaging their home.
Sequence of Returns Risk, like inflation, should be a real concern for the long-term investor. A near-retiree needs to have a plan to deal with it.
What do you think? Which of these methods have you incorporated into your plan to reduce SORR and why? What other methods could you use?
A variation of #1 for ER docs is to just pick up shifts when the net worth falls below a certain threshold.
Hmmm.. a shift tent instead of a bond tent?
What about a portfolio of REITS instead of bonds or physical real-estate to buffer the risk?
REITS tend to track between both bonds and stocks. It can buffer risk — it really depends on the REITs focus.
Vs Direct Real estate – at least residential, it tracks independently from equities, but has its own issues during economy wide stressors. Vacancy or worse–inability to pay rent and eviction protections — can hurt dramatically.
I’m a fan of real estate, whether public or private. But it’s not the same thing as bonds/cash.
My SORR plan is to work part time a few more years after I hit 25x.
If the market drops, I shovel all my money into stocks.
If the market doesn’t drop, then all the extra growth during those additional years will help when the market eventually does drop.
I prefer forecasting and planning. My portfolio includes real-estate, which will make the panning easier. I simply plan incomes as well as possible and use living-costs along the plan.
I’d also include a bond ladder in #4 as a way of having a cash bucket that offers you the option of spending it as each rung matures. We’re in the middle of a rather unique opportunity to lock in 4-5% interest rates on CDs, Treasury Bonds, and MYGAs (multiyear guaranteed annuities), which can be used to fund bond ladder rungs at rates that will likely outpace inflation over the next few years.
Maybe it’s unique. Maybe it’s just the way it’s going to be going forward. Certainly it’s the way it was for much of the past.
Agree–the current high yields make it a lot easier and more palatable to build a nice short-term cash/CD/short-term bond “bucket” for however many years make you sleep better at night (for me that’s 3-5 years). It was hard to buy into that when interest rates were zip. And based on how I interpret Bengen’s and Pfau’s data, once you make it past those early years without having to withdraw during a downturn, you can sleep a lot easier and loosen up the pursestrings a bit.
Good blog, lots of good advice. I love how you really get into the details on subjects; if physician would take the time to read these blogs, they would be on their way to financial independence.
One who has accumulated assets in many areas, I also have focused on the distribution aspects. One of the biggest surprises people face in retirement is taxes. They build up a great portfolio but continue to get hit with taxes on their gains. Or they accumulate money in real estate and then pay a hefty tax when they need to diversify for retirement income.
Getting a 7% return is one thing, getting a 5% tax free or after-tax return may be better.
I’ve spent my career in the tax planning area and have brought many strategies and subject matter experts to our firm MFC to help clients. My personal portfolio for retirement is made up of tax-free income, capital gains income and ordinary income. I’ve been able to convert my cash balance pension into tax free income. I took an appreciated asset and put it into a CRT to get a tax deduction and avoid tax on the sale of the asset. Diversifying how your taxed is a good strategy. The key in retirement is to keep your AGI low as it impacts Medicare cost and Social Security taxation.
It’s not how much you accumulate but what the net after-tax amount is.
I agree with your last line a lot more than your second to last line.
wouldn’t it be better to have a high AGI vs a low one, in retirement or not? Seems odd to set a goal of being income-poor in retirement.
Thanks for another excellent article. For #2 — does this mean that retirees are or should be watching the market/reading the economic news/etc or what is the best way to do this? One of the things I like about following the methods espoused by you and others is that you don’t have to do this during the accumulation period. Just wondering how people transition to doing this or what methods they use.
You don’t have to watch very hard to see that the market is down 30% in a given year and maybe you ought to tighten your belt afterward for a little bit.
More discussion on the WCI forum about this post than there is here:
https://forum.whitecoatinvestor.com/general-welcome/438413-discuss-latest-wci-blog-post-4-methods-of-reducing-sequence-of-returns-risk/page4#post438631
I believe that SORR is the biggest risk – especially to early retirees – that the early retiree will face financially (https://shawnpheneghan.wordpress.com/2018/02/23/retirement-planning/).
It is important to continue to save at the beginning of retirement. That is, plan on spending less than you make. I personally like to have necessary living expenses covered with guaranteed income. Then regardless of down markets, retirement is guaranteed. Any market gains can be used to “improve” your quality of life.
I retired at the turn of the century (at 48) and saw many folks return to work as the market failed to continue to produce the outsize returns of the late 20th century. While I had hoped for some gains, my retirement was never seriously impacted. Today, as the market has recovered, I have more income and money than I had even hoped for at retirement.
Well, that’s one way to completely eliminate SORR and actually a fairly commonly used one. But it does the downside of severely limiting what you spend to a number much less than what you can probably spend. It also pushes people into an income focused portfolio, which may not be ideal either.
Excellent post as are most of them 🙂 Long time reader here. I’ve been reading about SORR the last few years and one part I’ve never seen defined was how long does it last. While no one can ever be exactly certain, I’ve only seen it defined as the first few years in retirement. At what point does it become something you no longer have to really be concerned with? 4 years after retirement? 5?
Great article as usual
Regarding SORR
Im retiring December of this year
Lets say the markets are on the down side, should I not take my dividends and other distributions to fill my cash bucket?
Or just spend from my cash bucket during 2025-26?
Thanks
P
I don’t think there’s a right answer. There are pluses and minuses both ways. I think I’d refill that cash bucket even in a down market but maybe not in a massively down market. I mean, that’s kind of the point of a cash bucket.
On #2, Spending Flexibility, withdrawing some percentage of each recent annual portfolio value for portfolio longevity, seems sensible to me. Consider the RMD Portfolio Spending Plan of your age-based, annual RMD percentage of your stock and bond portfolio value plus spending annual dividends and interest. You can see next year’s income change as your portfolio value fluctuates this year, so there is not a sudden end-of-year surprise.
Christine Benz at Morningstar wrote about that spending method on April 23, 2023.
I like the RMD method for its simplicity. There are pros and cons compared to other methods for those who aren’t comfortable with just eyeballing it.
SORR is definitely a bigger risk than many retirees believe. Research that others and I have done indicates that it’s actually a bigger risk in retirement than the risk of poor returns.
Portfolio Charts has some great tools to allow investors to see which portfolios in many nations around the world had the lowest SORR and their corresponding performance. While it generates a lot of controversy, a modest allocation to gold (10-20%) has historically been quite beneficial to portfolios that were otherwise heavily weighted to stocks and bonds. Oddly, this finding has caused much angst in the personal finance community.
My plan from the beginning of my career has been to hold the line on spending and save as much as possible. I plan to continue this strategy throughout my retirement. Also the “bond tent” has been working well so far (holding individual bonds, to maturity).
Not sure if you’re saying you hold individual bonds and built a bond tent, but I just wanted to make sure you knew a bond tent wasn’t holding individual bonds.
Not a fan of solution #1 and #2. I didn’t work 40 years to “spend conservatively or “be flexible”.
#3 and #4 are essentially “taking money off the table”. You may want to look at HDO on seeking alpha. Rida Morwa has a method where you can have your cake and eat it too.
I have 50% of my portfolio in HDO with 9% dividends and total return over 5 years of 5% below the S and P and I live off of the dividends plowing 25% back into HDO. My dividends grow each year, I never have to sell into a down market and the “price” is 5% below market returns while living off the dividends. Better than your solutions in my view.
I disagree that dividend investing is some sort of free lunch. There are risks and downsides of focusing too much on income.
https://www.whitecoatinvestor.com/the-pros-and-cons-of-income-investing/
If nothing else, if you only spend the income and never touch principal, you will have dramatically underspent the amount you could have. You’re not immortal.
But it’s your money. Do what you like with it.