Retirees who wish to maintain consistent spending power during retirement face what is called sequence of return risk. Bad returns early in retirement can cause an investor’s capital base to erode such that withdrawals grow to an unsustainably high percentage of assets. When a market recovery eventually arrives, the capital base isn’t large enough to fully benefit from the rebound.
An unfortunate sequence of returns early in retirement can cut a retiree’s sustainable spending to a disappointing level. In this note, we discuss the things retirees can do to protect against sequence risk.
SEQUENCE RISK THROUGH THE GREAT DEPRESSION
It’s New Year’s Eve 1929. You are visited by a time traveler from the future. He reveals that you will die on January 1, 1960. Although you are disturbed by this revelation, you look on the bright side because now you know your money needs to last exactly thirty years. To your astonishment he also tells you what average asset class returns will be for the next three decades:
Wow! The trinity of retirement income risks (longevity, investment returns, inflation) have been removed from your retirement plan, or so you think.
With this information you decide to invest 100% of your retirement portfolio in stocks because they have the highest average growth rate. With inflation averaging 1.7% over the next 30 years, you conclude that an initial spending rate of 6.5% (8.2% minus 1.7%) will fund your retirement and a sizeable inheritance.
You decide to withdraw $6,500 at the beginning of each year from your $100,000 portfolio, adjusting the payments each year with inflation.
In Table 1 below we illustrate the progression of account value and spending under two scenarios. Sequence A shows returns in the order they happened. In Sequence B the order of returns is reversed.
Things get off to a rough start in Sequence A as your stocks decline 60% in the first three years. As a consolation, it’s also been a period of deflation during which your spending requirements have declined by 22%. You keep making withdrawals despite recent losses because you know the future will be better. Unfortunately, you run out of money in 1944 (15th year) and miss out on the best returns to come.
In Sequence B, the order of returns is reversed, and you earn above average market returns for the first two decades. By the 15th year (when Sequence A resulted in ruin) you have accumulated $335,000. Your children and grandchildren eventually enjoy an inheritance of $302,000 when you die.
Both Sequences A and B were subjected to the same average returns, but Sequence A resulted in ruin because it didn’t survive to earn the best returns, while Sequence B resulted in prosperity because it earned the best returns early in retirement.
REDUCING SEQUENCE RISK
Fortunately, sequence risk is a vulnerability that retirees can protect against. Here are some ways you can protect yourself:
- Choose a conservative spending rate
- Have safe assets to draw on during market corrections
- Reduce spending during market drawdowns
- Annuitize your spending needs
- Avoid retiring at the top of the market
Choose a conservative spending rate
In 1994, financial planner William Bengen popularized the “4% rule” as a conservative spending target. The rule states that retirees should be comfortable withdrawing 4% of their portfolio in the first year and adjusting that amount each year with inflation. This rule holds up well against U.S. market history for portfolio allocations between 50-75% equities.
For 100% equity portfolios, there is a greater risk of running out of money during retirement but also the possibility of a much higher standard of living. The sequence of returns is a big factor as to whether your retirement will be favourable or disappointing. In retrospect, the maximum sustainable spending rate was 4.6% in Sequence A but 9.0% in Sequence B.
Targeting a fixed withdrawal amount each year from a volatile portfolio is an inherently risky thing to do. Select a conservative spending rate to increase your odds of success. The 4% rule is a reasonable starting point for estimating overall spending power, but it’s not a year-by-year plan.
Have safe assets to draw on during market corrections
In the example above, sequence risk would have been lessened had the investor chosen a more conservative asset mix.
Table 2 illustrates how Sequence A and B would have performed with a balanced approach of 60% Canadian equities and 40% long-term Canadian government bonds.
As you can see, Sequence A survives until the 24th year. This result isn’t great but it’s nine more years than if invested only in equities. Furthermore, the sustainable spending rate is 5.7% which is quite reasonable. Sequence B fails in the 29th year, but with only a very small reduction in the initial spending rate (6.4% instead of 6.5%), the portfolio survives 30 years.
Sustainable withdrawal rates tend to be lower with balanced investing (compared to 100% equities) but they are also more stable. We presume that most people would consider it a fair trade to forgo significant upside to avoid major financial challenges partway through retirement.
Reduce spending during extended market drawdowns
The good news is that corrective action needn’t be too drastic for a balanced investor. For instance, in Sequence A, if the balanced investor used the 4% rule for the first five years, he could resume payments with a 6.5% spend rate in year six. However, if fully invested in equities, spending would have to follow the 4% rule for the first 16 years.
A balanced approach is good defence against sequence risk but isn’t always enough on its own. For instance, it would take a combination of a conservative initial spend rate and spending reductions to make it through the stagflation of the 1970s (burning less gasoline would have helped).
Annuitize your spending needs
As we wrote about here, retirees can guarantee much of their basic living expenses by maximizing inflation-protected government pensions. With this approach, a larger proportion of assets are shielded from the market volatility that causes sequence risk. Then, it is only discretionary spending that might have to adjust to market conditions.
Avoid retiring at the top of the market cycle
You are most likely to reach your financial goal near the end of a long bull market in stocks. However, your portfolio value could be somewhat of an illusion due to the cyclical nature of markets in which periods of market strength are followed by market corrections or even extended bear markets.
Perhaps the worst time to retire in recent history was in 1965. In the previous seven years from 1958 to 1964, cumulative inflation was only 11%, Canadian stocks returned +150%, and U.S. stocks advanced +190% (in Canadian dollars). Many people would have achieved their financial goal after this long run of strong investment returns. But the era of price stability and high real investment returns was coming to an end. Inflation started to climb in the late 1960s, then soared throughout the 1970s and early 1980s. The bear market from 1973-1974 ravaged portfolios while prices increased a staggering 23% in just two years.
Following periods of outsized gains, you should expect as a matter of prudence that portfolio returns over the next decade will be disappointing relative to recent returns. Investing defensively at this time should help reduce sequence risk.
QV CAN HELP WITH YOUR RETIREMENT PLAN
QV can help you with your retirement plan, including an assessment of how sensitive your sustainable spending target is to key variables such as longevity, market returns, and inflation. Contact your Investment Counsellor to start the discussion.
FOR ADDITIONAL READING:
https://www.retailinvestor.org/pdf/Bengen1.pdf
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3501673
