By Anthony Watson, Guest WriterWhen you’re young and investing for a far-off retirement date, the only risk you’re really concerned with is volatility—or how much your portfolio swings in value in response to good and bad economic news. Risk management, in this case, is mainly accomplished through building a properly diversified portfolio with an asset allocation to stocks and bonds in a proportion that allows you to meet your return goal while not exposing you to volatility you cannot handle.
The problem is that most advisors and individuals continue to view the asset allocation decision as the primary tool to manage the new risks that emerge as one nears and enters retirement. Of primary concern among these new risks is the Sequence of Returns Risk (SORR). The greater your portfolio’s volatility, the more exposed you are to the negative exponential effects a bad sequence of returns can have on your portfolio’s longevity, placing you at a greater risk of exhausting your resources prematurely.
The good news is there are other tools and strategies better geared toward managing SORR. As a bonus, many of these tools and strategies allow you to maintain a higher allocation to stocks (and, thus, return potential) than would otherwise be the case as you enter and enjoy your retirement.
The Definition of Risk
Most know if you invest all your money in a single stock, you risk the loss of your investment. In 1941, General Motors made 44% of all the cars in the US, and it had become one of the world’s largest corporations. In June 2009, General Motors filed for Chapter 11 bankruptcy, wiping out shareholder stock value. If you had all of your portfolio invested in GM, you’d be in trouble. A portfolio of individual stocks exposes you to unsystemic (or company-specific) risk. This kind of risk exposes you to permanent loss. This is why diversification of your investments has long been stressed as best practice.
Fortunately, investors today have access to a wide variety of low-cost, tax-efficient, well-constructed index fund ETFs. With only a couple of index fund holdings, investors can build portfolios that give them exposure to thousands of different companies across the globe. When you have a properly diversified portfolio, risk is no longer defined by permanent loss but rather by volatility (i.e. standard deviation). When times get tough, your portfolio’s value will fall as economic conditions threaten the performance of all companies. Still, if you can hold steady, values will return when the economic threat dissipates. Even if a few companies went bankrupt, your portfolio wouldn’t really feel it since their individual effect on your portfolio gets diluted or diversified away.
More information here:
An Appropriate Amount of Investing Risk
25 Things You Must Do Before You Retire (and Here’s a Checklist to Help)
Your Asset Allocation Controls Your Volatility
Once you have built a diversified portfolio, your asset allocation decision between stocks and bonds controls your level of volatility. Stocks have higher return potential than bonds, but they also add more risk in terms of their possible variation in value. In other words, the greater the proportion of your portfolio allocated to stocks, the greater the potential variation in value swings you can expect.
The risk of being too exposed to bonds (or conservativeness) is that your long-term returns will suffer (especially after inflation). The risk of being too exposed to stock (or aggressiveness) is that you risk selling at the bottom of a market downturn because you cannot “stomach” the decline and then you most likely miss the recovery, making what was a paper loss an actual loss.
Introduction to Sequence of Returns Risk
Most WCI readers will be familiar with the concepts of diversification and the asset allocation decision. Less familiar to many is the concept of SORR and the danger it poses as you near and start retirement.
When amounts of money are coming into or out of a portfolio, the average return on a portfolio matters much less so than the actual sequence of returns you experience. For example, suppose you had two retirees (A and B) start with $3 million portfolios, and each take $150,000 in annual withdrawals:
You can see that both retirees earned the same average return of 4% on their portfolios over the 10 years, but retiree B is left with ~$890,000 (or 32%) less.
The retiree in Scenario B was irreparably harmed by continuing to withdraw $150,000 per year from assets that were down in value earlier in retirement. Not only did it take more assets to generate the $150,000 per year because of depressed market prices, but those assets were also gone from the portfolio and unable to participate in the ensuing impressive market rebound in years 4 through 10. The timing of outflows under Scenario B in the presence of a negative sequence of returns had a material adverse impact on the retiree.
More information here:
4 Methods of Reducing Sequence of Returns Risk
The “Retirement Red Zone”
Prudential Insurance coined the term “Retirement Red Zone” to represent the five years before and after retirement where an individual is most exposed to Sequence of Returns Risk. In the prior example, Retiree B showed what could happen if you experience a negative sequence of returns just after retiring.
But what about the risk leading up to retirement?
Your portfolio’s value in the five years leading up to retirement will be determined mostly by your sequence of returns, as the relative impact of contributions is dwarfed by the effect of compounding returns. For example, say a couple is five years from planned retirement with an investment portfolio of $2.5 million. Working with their retirement specialist, they determined that $3 million would be the proper portfolio target to support their desired retirement lifestyle. In this case, assuming no contributions to simplify the example, this couple would only need to earn a 3.71% average annual rate of return to close the gap and meet their goal. Closing this gap sounds easy, given the historical average annual return from a 60% stock/40% bond portfolio. Vanguard’s LifeStrategy Moderate Growth Fund (VSMGX), which tracks a diversified 60% stock and 40% bond portfolio, has returned an average of 7.35% over the last 30 years (since 1994).
Here is where SORR comes into play. What if, two years before retirement, this couple experiences the following negative sequence of returns?
Experiencing this negative sequence of returns so close to the couple’s planned retirement date turned what once looked like an easy glide path into retirement into a shortfall of over $600,000 by their planned retirement date.
More information here:
The 4% Rule and Safe Withdrawal Rates
The Silliness of the Safe Withdrawal Rate Movement
Asset Allocation Is the Wrong Tool for the Job
For decades, industry professionals have known about SORR. It is the Sequence of Returns Risk that causes the wide variation of outcomes in Monte Carlo simulation analyses. It is also why you’ve probably heard of the ridiculous rule of thumb: “Hold no more than 100 less your age in stock.” The financial advisory industry’s narrow focus on money management (and collecting fees on the size of a portfolio) has led to the asset allocation decision being the only tool in their toolbox.
Trying to manage your Sequence of Returns Risk through your asset allocation decision is a bit like trying to eat spaghetti with a spoon. It’s not the best tool for the job. If a spoon is your only option, it will have to do. Clearly, if you reduced your stock exposure—and thus your portfolio’s potential volatility—you would lessen your exposure to a negative sequence of returns. But this strategy does little to mitigate the real cause of the problem, and you are giving up higher potential returns that are critical to your portfolio’s longevity and standard of living in retirement.
The Right Tools for the Job
Use a fork instead. The harm that a negative sequence of returns can have is caused by having to sell and withdraw assets when values are down. The key is to have a game plan in place that allows you to avoid selling off assets at steep losses to fund needed expenses. Following are some strategies/tools made for this task:
Adequate Savings Buffer and Income Ladder
Having an adequate savings buffer combined with a 12- to 18-month income ladder to ride out the average recession will dramatically reduce the impact a negative sequence of returns could have on your portfolio. If you pre-fund 12-18 months of your income needs when markets are “high,” you will not be forced to sell off assets at a steep discount should markets fall suddenly in response to a negative economic event. Instead, you would simply cease buying new rungs on the ladder until markets recover.
Home Equity Line of Credit or a Pledged Asset Line of Credit
Having access to a Home Equity Line of Credit or a Pledged Asset Line of Credit (a brokerage-secured line of credit) can fund a “shock spending event” or income needed after your ladder runs out (assuming markets were still down). It is much better to pay a little interest expense for a brief time than to sell an asset at a 20%+ loss. Given bear markets have only exceeded 24 months one time since the Great Depression (during the 2000-2002 Dot Com Bust), you likely won’t need to borrow for long. Plus, interest rates are lowest at this point in the economic cycle as the Federal Reserve decreases rates to fight the economic downturn. Having access to a credit line to protect against a disaster can also reduce how much of a savings buffer you need to maintain, which means more can remain invested.
Rules-Based Flexible Spending Strategy
While not an easily implemented DIY solution, employing a rules-based flexible spending strategy that uses guardrails to inform when increases are allowed or decreases are needed will help you manage your SORR over the long term. You have no idea what path of returns you will be on during your 30+ year retirement. This is why a Monte Carlo analysis usually shows a very broad range of outcomes, spanning perhaps from running out of money too soon to passing away with more money than you started. A rules-based flexible spending strategy corrects the flawed Monte Carlo analysis assumption that changes couldn’t or wouldn’t be made along the way in response to what is happening in reality. A rules-based flexible spending strategy will ensure you make spending reductions in advance of reaching a danger zone while also ensuring you are increasing your spending along the way if you end up with a good path of returns so you can always make the most out of your retirement.
Most financial advisors focus on money management and “specialize” in accumulation. Little thought is given to strategies outside of the money management process. Retirement, or decumulation, is a different animal that exposes one to many new risks that must be identified and managed. I hope you have come to see there are better ways to manage your Sequence of Returns Risk than simply reducing your asset allocation to stock.
How do you plan to manage SORR as you get close to retirement? What other risks will you try to mitigate?
12-18 months expenses set aside to ride out downtown for SORR might not be enough. That might be enough for only a common bear market or correction.
The Great Inflation and Great Depression impacts on portfolios lasted each far longer than 18 months.
Are similar periods likely to be repeated? No, not likely, but theoretically possible. Plan accordingly, advised by history, not by disregard of history.
Hi Rob,
You are 100% correct and I could not agree more. That is why a 12 to 18 month ladder can not be your only layer of defense against SoRR. While adequate to protect against most common bear markets or corrections one is likely to experience, one has to be prepared for something longer or unprecedented. The tool we like to recommend for a second layer of defense to protect against something that can last longer is a Home Equity Line of Credit (HELOC) or a Pledged Asset Line of Credit (PAL)(a line of credit based on holdings in a brokerage account). This may sound unconventional, but I would rather have a client borrow for a short time (and pay a little interest expense — recall interest rates are lowest during a bear or correction) than sell off investment assets at a steep discount. The alternative is to keep a much larger savings buffer, but given the low odds of actually ever needing this savings buffer, I am not convinced it’s worth the additional cash drag on the portfolio.
Thank you for reading the article and providing your comments!
Anthony Watson
Taking on more debt (eg. HELOC) with interest to fund living expenses when ability to repay is at risk because of economic uncertainty or because of inability to return to work would be shocking to my grandparents who lived through the Great Depression and to my parents who lived through the Great Inflation.
Many financial writers suggest other strategies such as Liabilities Matching Portfolio which increase cash or ladder of fixed income maturities for the expenses expected for the term over which SORR is a concern (e.g., five years before and after retirement) with the balance of assets in a more conventional asset allocation strategy.
Monte Carlo analysis has its place but the data inputs don’t go back very far from historical perspective. Unless they have enough assets relative to expected expenses to never worry (eg. Warren Buffett), people approaching or in early years of retirement often have greater desire for certainty than for for upside.
Those who ignore economic history might blissfully SWAN (sleep well at night) but can wake up to some rather unpleasant surprises that can be anticipated in planning.
Thanks for the article. I’m surprised by the sole focus on stocks and bonds, without mentioning the potential to significantly reduce portfolio volatility (and income volatility) by diversifying into other asset classes such as real estate (especially private real estate rather than public REITs) and managed futures. Adding non-correlated assets can dramatically dampen the volatility in the portfolio. Managed futures can be expensive to add, but now there are relatively low-cost ETFs (e.g., DBMF, KMLM, etc.) and even mutual funds (e.g., BLNDX) that provide that exposure without the ultra high fees of hedge funds and similar types of funds.
Hi John,
Thank you for reading the article and providing your thoughts! You bring up an interesting point that one could seek to reduce volatility further through improvements in their portfolio’s construction. The right answer here is going to be dependent upon one’s investment philosophy. I am a “bogle-head” and am adverse to adding “excessive expense” to the portfolio for the sake of reducing volatility. “Excessive expense” is a relative term, but we like to keep our investment portfolios in the 5 bps to 10 bps range. We also are adverse to adding asset classes (like commodities) that can reduce volatility, but don’t contribute a real expected real return (i.e., a return above the inflation rate) over time to the portfolio. Again, these opinions are subjective and will vary based on one’s investment philosophy so there is no clear right or wrong answer.
Thanks again!
Anthony Watson
I generally agree that it is important to keep expense ratios as low as reasonably possible. However, I would point out that keeping a cash buffer introduces an indirect cost to the portfolio as well, so depending on the size of your cash buffer and the allocation to bonds you might have just as low a net CAGR as someone who has a higher allocation to stocks but adds managed futures to the portfolio in place of some of that bond/cash allocation. Also, if you look at the example ETFs/mutual funds that I cited, they have pretty good total return CAGRs since inception (KMLM: 10.14% since January 2021; BLNDX: 14.17% since January 2020; DBMF: 9.24% since June 2019). So, you don’t have to introduce a 0% real return for managed futures or commodities as you suggested in your comment.
Thanks for the recommendations to look into managed futures. Those are interesting. It looks like some of them play pretty heavily off bonds. I would be concerned about the complexity and the high expense ratios, even the “cheap” ETF at 0.9% ER has a 0.4% bid/ask spread.
I also think an investment “allocating up to 20% of its total assets in its wholly-owned subsidiary, which is organized under the laws of the Cayman Islands” is a huge red flag for me.
Well the Cayman Islands subsidiary is a normal practice for funds investing in futures – it is a way of converting ordinary income into LT capital gains and making the income from futures much more tax efficient.
Working a few more years, even part time, after hitting your number would work in most situations. That’s my SORR plan.
Market goes up those years, you have a bigger pot & better ability to withstand market drops.
Market goes down those years, you’re buying more stocks when they’re low and not withdrawing from your portfolio.
Some people don’t have the option to work a few more years, but the average reader here likely will hit their number way before normal retirement age.
I’m not sure how relaxing needing to borrow money from your house would be. You don’t know if the stock downturn will be a minor one lasting a few months like Covid or the second Great Depression lasting four years.
The income ladder is asset allocation though as you are allocating a certain percentage to cash / t bills instead of medium or longer term bonds.
Spending flexibility is great, but that means you need more money. That is the bottom line, more money makes things easier.
I’d suggest a paid off house (less money needs to be generated so can be more flexible), social security at 70 (more safe income), perhaps a tips ladder from retirement age until age 70 for safe baseline expense spending before social security kicks in.
The Flexible Spending part of “Rules-Based Flexible Spending Strategy” in retirement is obvious to me, even before I understood SORR. However I’m unclear on what the rules should be.
We should not time the market, and delaying selling stocks in a down market until it upturns is market timing. The main thing that gets me to follow our plan of having five years of projected spending on hand is knowing if I end up delaying and then need a lot more than planned (eg new cars/ toys/ etc PLUS the next 4-5 years usual expenses) in one year the tax bill will be punitive and if it’s still a down market I’ll be sorry, so spread out Uncle Sam’s and our share evenly over the years, delaying only where leaving it as an inheritance might decrease the tax paid. And when I fret that I might be missing the next surge I look back 1 2 5 years as needed to assure myself that the market is up at least from that many years ago.
So for us the rule is (still trying to get myself to follow it) to go on and move 1 year of expected future expenses (5 years out, less if your cash profile calls for less of a cushion) from portfolio annually. Or a fixed percentage withdrawal of the portfolio as it is, and make do with less in down markets.
Any market timing can be rebalancing the various asset proportions via targeted sales for the withdrawal. Okay, I think I have my rule now- just to crystal ball guess what our unscheduled expenses will be 5 years from now and whither go the tax rules.
WCI articles keep alerting me to new to me factors- like IRMAA and the ACA tax- to factor in when spreading out the Roth conversion piece of our puzzle and trying to increase our spending. Not yet buying first class tickets but headed that way.
If you want rules, there are ~300 different sets you can use, all with their pluses and minuses in the past data. I’ll be writing a post on some of them soon.
Is delaying selling stocks in a down market really market timing though? You’re responding to something that already happened; not in anticipation of what will happen.
When stocks have already plunged, you should be selling from bonds or using cash to maintain your asset allocation.
Maybe this is simpleminded, but why wouldn’t someone just rebalance into their fixed allocation yearly on the way down, like they did on the way up? All those buckets and floors and ladders… sounds like a construction zone. What am I missing?
Brian, I agree with you. I know this is a controversial topic, but forget the rules and buckets! The key is asset allocation (for example 60/30/10) with annual rebalancing. I learned this revelation from an article by Michael Kitces (https://www.kitces.com/blog/managing-sequence-of-return-risk-with-bucket-strategies-vs-a-total-return-rebalancing-approach/), who shows that “once a portfolio is going to be rebalanced every year, the impact of decision rules is made null and void and the buckets are essentially just an asset allocation mirage.” It has greatly simplified my retirement withdrawal strategy.
Thanks for the great link Jason. Always nice when data makes things simpler instead of more complicated. I’m 55/25/20 and I rebalance on January 10 every year. Doesn’t matter if money is coming in or going out, or whether I am retired or just loafing around for a year or two. I don’t even know, nor do I need to.
Thanks for the well written and thought provoking article. I love reading posts that tie theory and concepts to practical action that can be taken in the real world.
As I was reading this I kept thinking, “Doesn’t the Safe Withdrawal Rate account for SoRR?”.
My understanding is that the 4% SWR is built to withstand the volatility of historically bad sequence of returns and that a central variable in the Trinity Study is asset allocation.
The concept of the SWR is far from perfect with notable flaws, a fixed withdrawal rate being one of them, and the author points out that having some adjustable withdrawal rate expectations is wise.
However, I guess I don’t see asset allocation as “the wrong tool”. If we find validity in the Trinity Study then comparing asset allocation to a a spoon for eating our retirement spaghetti is not fair, maybe a spork, but certainly not a spoon.
Exactly. According to the Trinity Study, if you have a portfolio of 75/25 stocks/bonds and a 4% withdrawal rate, you will still have money left over after 30 years even if the Great Depression starts the day you retire. If that’s not enough comfort, have 2 years of expenses in cash on hand, and do what Jim says: adjust as you go.
Thank you Anthony and Jim for exposure to this topic. I look forward to more discussion on withdrawal strategies and concepts in future posts!
I don’t view creating an income ladder as anything unique from what is already part of any normal asset allocation. You take a portion of your fixed/bond portfolio and create a cash bucket that supplies however many years of income needs that allows you to feel comfortable with whatever sequence of returns risk you want to cover and it is still part of the less risky part of your allocation. Or you create a constant income stream by buying a SPIA from a portion of your fixed/bond portfolio and it is surely part of the less risky part of your portfolio. This all still sounds like asset allocation to me.
I sold a bond fund after the 2022 market correction and invested in a 5 year CD ladder (favorable because of current interest rates) that has been rolling for a year. Rebalancing from the current year market gains in stocks to the CD ladder added a few more dollars to help mitigate SORR in the out years. Hopefully rebalancing in the future will help, but if it doesn’t, we’ve created a ladder that will allow us to cover future RMD needs in 2027 and beyond. We are basically matching the cash flows from dividends, interest and CDs that are maturing with the future liabilities (RMDs) that we will need. This all sounds like asset allocation to me. I don’t view asset allocation as folly.
Flexible spending is definitely a good idea to help mitigate SORR. Fortunately, we’ve been blessed with a portfolio that will supply more than we need by just taking RMDs. A HELOC really isn’t necessary in our case, but I can see where it might be helpful if you can’t otherwise meet your cash needs in a down market when selling depressed assets are unwise.
JP Morgan had a recent guide to retirement.
https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/retirement-insights/guide-to-retirement-us.pdf?utm_source=theideafarm.com&utm_medium=referral&utm_campaign=record-highs
They have a pretty simple recommendation of a dynamic withdrawal strategy based on the return on your portfolio (slide 35).
They recommend,
Annual return on portfolio is:
less than 5%, withdrawal remains the same as the prior year;
between 5% and 10%, withdrawal is increased by actual inflation (CPI-U);
greater than 10%, withdrawal is increased by actual inflation +3%”
This strategy survived even during the poor SORR period of 1966-2000 according to their data.
It’s pretty easy to come up with a rule that would have worked in the past. That’s why there are 300 of them and everyone argues about which one might be best in the future.
It’ll be interesting to see your upcoming article on it, as you mentioned earlier.
How is keeping an adequate savings buffer and prefunding 12-18 months of income different from having a higher bonds/cash allocation? Sounds like the same thing to me with a different name.
Thank you for the article. I do have a question. I am 74 and have a good IRA. This forces an ever increasing withdrawal rate. Therefore, I cannot control the amount of withdrawal based on how well or poorly the market does. I have a couple questions. In such circumstances do you advise considering—
1. Taking some of the IRA in a backdoor Roth, depending on my tax bracket (IRA + Social Security)—even though it is tied up for 5 years?
2. Paying of IRA from savings accounts in down years and transferring the equities and bonds into a taxable accounts so that selling of the depressed stock and/or bonds is not necessary?
1. Roth conversions do not take the place of required minimum distributions (RMDs), but you can reduce future RMDs by doing Roth conversions now. None of this has anything to do with the Backdoor Roth IRA process. More info on all this here:
https://www.whitecoatinvestor.com/roth-conversions/
https://www.whitecoatinvestor.com/dont-fear-the-reaper-rmds/
https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/
As a general rule, the time to do Roth conversions is BEFORE taking Social Security at 70, not after. You’re a little late on this and thus it is less likely to be worth doing now than before. Also, RMDs ARE affected by market performance. They’re determined by your account balance at the end of the prior year. And just spending your RMD is probably the best advice I can give you. If you don’t need to spend it, that’s one of the best problems to have in personal finance, not one to complain about.
2. An RMD just says you have to move the money out of an IRA and give the government its share. It doesn’t mean you HAVE to spend it. You can always reinvest it in taxable. If that makes you feel better, then do that. But trust me when I say you can safely spend your RMDs even in down years and you are still very unlikely to run out of money. Your RMD at 74 is only about 4% of the balance. That is a very sustainable withdrawal rate for a 74 year old. Your life expectancy is only about a decade. Even if you live twice that long, 4%ish is going to be just fine. And by the time your RMD gets really high like 10-11%, you’re going to be in your 90s with a 3 year life expectancy.
Some bonds are volatile. Long term treasuries have a standard deviation similar to a total stock market fund. This high volatility is typically good since they are negatively correlated with stocks, which reduces overall portfolio volatility and introduces rebalancing opportunities. Periods of rising inflation, like 2022, hammer both stocks and bonds though.