Your need to reduce the sequence-of-return risk
You might not think it’s a risk at the moment, what with the market close to all-time highs. But at some point the market will fall again. And when it does, current and future retirees will get to experience what the experts refer to as sequence-of-returns risk—the risk that you’ll withdraw money from a nest egg that keeps falling in value, especially in the early years of retirement.
“One of the biggest risks to a successful retirement is the exposure of savings to one or more adverse negative investment returns in the early stages of the retirement,” W. Van Harlow, director of research at the Putnam Institute, wrote in a recent paper.
In truth, there is some debate among academics and advisers in the retirement-planning world about whether this risk is real or not. In one corner, for instance, are advisers who say retirees who withdraw money from nest eggs that fall in value, including during the early stages of retirement, don’t really run out of money, nor do they have to lower their standard of living, even in the late stages of retirement.
And in the other corner are academics such as Van Harlow and others who publish paper after paper warning of this risk and the need to deal with it somehow, someway.
The risk, they say, is real and can put a big wrench in one’s retirement plans—as those who experienced it in 2000 or 2008 can attest. (Many who experienced sequence-of-return risk in 2000 and 2008 had to delay retirement or return to work, or reduce their lower their standard of living, or live in fear of running out of money, or all of the above.)
“Retirees need to know that—if they are invested in assets with a risk of negative returns such as stocks and bonds—their ability to withdraw a steady amount to provide income throughout retirement is not certain,” said Brandon Bellin, senior associate actuary at Securian Retirement.
“If their portfolios suffer significant market losses early in retirement, this can result in their money running out much earlier than expected, or force them to take a lower withdrawal amount—i.e. live on less—to help prevent that. This ‘sequence-of-returns’ risk is real, as many, especially newer, retirees experienced with the 2008 market downturn.”
Who to believe? Well, the research produced by experts from around the globe is extensive and—without examining each and every assumption used—seems hard, if not impossible, to dispute.
Here are links to just some of the many recent studies, white papers, and articles on the subject:
And then there are books that discuss how to deal with sequence of return risk, including “Are You a Stock or a Bond,” by Moshe Milevsky; “The New Wealth Management: The Financial Advisors Guide to Managing and Investing Client Assets,” co-author by Harold Evensky, Stephen Horan, and Thomas Robinson; and “Retirement Income Redesigned: Master Plans for Distribution—An Adviser’s Guide for Funding Boomers’ Best Years,” which was edited by Evensky.
By contrast, the research suggesting that sequence-of-returns risk is not something about which to be concerned is, well, not nearly as vast. (I couldn’t find much that said it was nothing about which to worry, quite frankly.)
So, given that sequence-of-returns risk is real and not imagined, what can you do to protect yourself?
Build a cushion
“Anecdotally, I would advise that the future is always fundamentally unknowable and any projection using Monte Carlo or other tools should primarily be used as a long-term ballpark guide for general planning purposes,” said Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research. “Anything can happen in the short-term, which is why retirees should build in a reasonable cushion to stay flexible.”
Some advisers are fond of setting aside two years of living expenses in cash as a way to avoid or mitigate the effects of sequence of return risk. Instead of withdrawing 4% per year from their portfolio, they set aside two years of living in liquid cash alternatives. That way, they don’t have to worry about the negatives effects of falling markets on their withdrawal strategy.
Start out with a reasonable asset allocation
Common sense, said Spiegelman, also tells us that a severe market drop early in retirement will translate into either a lower withdrawal rate to achieve the same time period or a shorter time period for sustainable withdrawals using original assumptions.
“But, more important than all the academic number-crunching is the psychological impact of an early-retirement market drop,” said Spiegelman. “Historical hindsight tells us that the average individual tends to bail out at the point of greatest pain, which sadly is also the point of greatest opportunity for those with both the resources and risk tolerance to persevere.”
That’s why Spiegelman and others say it’s important to start out with a reasonable asset allocation and a plan that allows for the greatest amount of flexibility. “We generally recommend that a retiree who needs to rely primarily on the portfolio for retirement should allocate roughly 40% to stocks and certainly, no more than 60% and perhaps less than that if the person is especially risk averse.
“That way, even if the market drops 50% your portfolio is only down 20%,” he said. “Plus, you have the flexibility to tap fixed income and cash while your stock allocation has a chance to recoup. Allocating too much to stocks means you might have to sell at the worst possible time.”
Others are much more conservative. Van Harlow, in one of his papers, recommends that retirees commit no more than 25% to stocks and something in the range of 5% to 10% would be optimal.
Of course, Spiegelman said outside sources of income could allow for a greater equity allocation and everyone needs to find their own comfort level. “Whatever that allocation level is, ask yourself if you would be willing and able to stick with it in the event of a 40% to 50% market correction in the first five years of retirement,” he said.
Don’t rely on 4% withdrawal rule
Common rules of thumb such as the 4% withdrawal rule—withdrawing 4% of your assets during the first year, and then increasing that dollar amount by inflation thereafter—are useful starting points. “But those rules simply attempt to balance a decent income with a low risk of running out of money too early,” said Bellin. “They have worked well for many over time, but can’t eliminate the sequence-of-returns risk. If you’re unlucky enough to retire at a particularly bad time, it can mean accepting a lower standard of living than you planned.”
Adjust withdrawal rates if need be
In their paper, Frank and Blanchett recommend that adjust your withdrawal rate as market return trends suggest; that you adjust your portfolio allocation to mitigate exposure to negative market returns as market trends suggest; and that you start with a reduced withdrawal rate to reduce exposure to the impact of declining markets on the probability of failure.
Consider downside hedging
In another paper on the subject, titled Improving the outlook for a successful retirement: A case for using downside hedging, Putnam’s Van Harlow suggests that hedging with “costless collars” or with put options can eliminate or significantly reduce funding shortfall risk for a retirement portfolio.
In addition, his paper shows that, for a given level of shortfall risk, hedging can increase the income generated by retirement savings by almost 40%.
Thus, he wrote, that downside-hedging strategies within retirement portfolios appear to offer attractive benefits to the retiree worried about outliving his or her income resources.
One way to hedge the sequence-of-returns risk, according to Van Harlow’s research, is with absolute-return funds.
In 2009, Putnam launched four absolute-return funds, which were designed to seek positive returns above inflation over a full market cycle regardless of market condition, with lower volatility. Putnam’s point of view is that while absolute-return strategies cannot guarantee positive results over an investment cycle, they do have a lower risk profile. And this means they could help limit losses in a down market.
Consider guaranteed sources of income
Fortunately, said Bellin, the lessons of 2008 are resulting in many strategies being brought forth in the financial adviser community that attempt to further minimize or even eliminate that risk.
A common theme, he said, is to make sure you have enough sources of guaranteed income that won’t be affected by market downturns. “Social Security is one such source that almost all retirees have, but it often isn’t enough on its own to guarantee the minimum standard of living the retiree desires,” Bellin said. “Pensions can help fill in that gap, although the trend away from employers offering traditional pension plans means most people retiring today do not have one.”
As a result, he said, annuities are increasingly gaining favor as an effective way to guarantee the portion of needed income that Social Security doesn’t supply. “There are a number of varieties that meet different needs, but in its simplest form the retiree uses a portion of their assets to purchase a fixed, guaranteed stream of income for life and often the life of their spouse.”
“Once a retiree has their basic needs secured through guaranteed sources of income, they can invest the rest of their money in stocks, bonds, and other risky assets to give them some upside without having as big of consequences if those assets decline in value,” said Bellin.
It’s quite possible that you will never experience the sequence-of-returns risk and it’s possible that even if you do, you won’t experience the worst-case outcome. But given the preponderance of evidence that suggests that the risk is real, and given all the strategies you can use to mitigate it, why wouldn’t you protect against sequence-of-returns risk?
Robert Powell is a featured writer on the MarketWatch Retirement blog, a Research Fellow at the California Institute of Finance, and a Featured Contributor here on the CIF blog.