By Dr. Jim Dahle, WCI Founder
I 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 with 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.
While just spending less certainly works, there are other options that 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.
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 was much more attractive near the end of 2023 when TIPS had real (after-inflation) yields of 2.34%-2.49% rather than the negative real yields they had just two years before.
Income from a conservatively managed and leveraged real estate portfolio can also be used similarly, although they 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.
#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 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:
#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.
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 have an effect on 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 or real property.
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.
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, there is some data suggesting 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? Comment below!