Sequence of Returns Risk is a little talked about, but critical, risk in retirement. Sequence of Returns Risk, or Sequence Risk for short, is the risk that you will need to take distributions from your investment portfolio during periods where the market has recently gone down. Taking distributions when the market has gone down effectively “costs” more than at other points in time.
This means that managing your Sequence Risk is a crucial part of your retirement income planning process.
In this article we will look at four different techniques that you can use, independently or in conjunction with each other, to deal with Sequence Risk.
The first option for managing sequence risk in retirement is to spend conservatively. Retirees want to keep spending consistent on an inflation-adjusted basis throughout retirement.
With a total returns investment portfolio, an aggressive asset allocation provides the highest probability of success if the spending level is pushed beyond what bonds can safely support and annuities are not otherwise considered.
The primary question with this strategy is how low spending must be to ensure a sufficient probability of success. Combining an aggressive investment portfolio with concerns of outliving your assets means spending must be conservative.
Ultimately, a fearful retiree may end up spending less with an aggressive investment strategy than they might have had they focused more on fixed income assets.
This aggressive portfolio/conservative spending strategy can be rather inefficient, as the safety-first school argues that there is no such thing as a safe spending rate from a volatile investment portfolio.
While this approach seeks to mitigate sequence of returns risk, it can actually increase it, as there is no lever to provide relief after a market decline.
The only solution is to sell more shares to keep spending consistent.
Maintain Spending Flexibility
The next approach keeps the aggressive investment portfolio of the prior strategy while allowing for flexible spending. Sequence risk is mitigated here by reducing spending after a portfolio decline, thereby allowing more to remain in the portfolio to experience any subsequent market recovery.
At the extreme, Dirk Cotton demonstrated at his Retirement Café blog that a strategy of withdrawing a constant percentage of remaining assets eliminates sequence of returns risk. Just like investing a lump sum of assets, the order of returns no longer matters.
Such a strategy results in volatile spending amounts, so most practical approaches to flexible retirement spending seek to balance the tradeoffs between reduced sequence risk and increased spending volatility by partially linking them to portfolio performance.
Reduce Volatility (When It Matters Most)
A third approach to managing sequence of returns risk is to reduce portfolio volatility, at least when it matters the most. A portfolio free of volatility does not create sequence of returns risk.
Essentially, individuals should not expect constant spending from a volatile portfolio. Those who want upside (and, thus, accept volatility) should be flexible with their spending and should make adjustments.
Retirees can reduce volatility in several ways, at least on the downside, and at least when the volatility could have the largest impact.
Spending could be kept constant if the portfolio is de-risked. To really get constant spending, you should look to hold fixed income assets to maturity or use risk-pooling assets like income annuities.
Consider, for instance, traditional defined-benefit pension systems that can reduce volatility’s impact on the pensioner’s income. Defined-benefit pensions provide a way to pool the sequence of returns risk across separate birth cohorts, thus reducing exposure.
Individuals are entitled to benefits based on their contributions into the system, not market performance. With defined-benefit pensions, some individuals will receive less than they might have by investing on their own, but others will receive more.
In this regard, defined-benefit pensions are essentially a separate asset class that most investors should find very valuable, as pensions diversify sequence of returns across time and allow them to collect income based more closely on the average returns over long periods.
Other approaches to reducing downside risk (volatility in the undesired direction) could also be considered. For instance, a rising equity glide path in retirement could start with an equity allocation that is even lower than typically recommended (in safe withdrawal rate research literature) at the start of retirement, but then slowly increase the stock allocation over time.
This can reduce the probability and the magnitude of retirement failures. This approach reduces vulnerability to early retirement stock market declines that cause the most harm to retirees.
Asset allocation could also be managed with a funded ratio approach, in which more aggressive asset allocations are used only when sufficient assets are available beyond what is necessary to meet retirement spending goals.
Finally, financial derivatives or income guarantee riders can be used to place a floor on how low a portfolio may fall by sacrificing some potential upside.
Buffer Assets – Avoid Selling at Losses
The final category of approaches to manage sequence risk is to have other assets available outside the financial portfolio to draw from after a market downturn.
Returns on these assets should not be correlated with the financial portfolio, since the purpose of these buffer assets is to support spending when the portfolio is otherwise down.
An old strategy in this category is to maintain a separate cash reserve, perhaps with two or three years of retirement expenses, separate from the rest of the investment portfolio.
While this is a safe approach, one disadvantage is that the cash reserve could have otherwise been invested to seek higher returns than cash provides. Cash can be a drag on the portfolio, and in recent years more attention has focused on other alternatives.
The two main alternatives that I have discussed here and at my website are to use the cash value of permanent life insurance policies as a reserve, and to open a line of credit with a reverse mortgage to serve as a reserve.
I discuss the latter strategy extensively in my previous book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement.
Managing your Sequence Risk is an important aspect of retirement planning, helping to navigate the uncertainties of market fluctuations while reducing the impact of that volatility on your retirement income. By exploring strategies such as spending conservatively, maintaining your spending flexibility, reducing portfolio volatility, and utilizing buffer assets, you can reduce the impact of Sequence Risk on your retirement plan.
To find out more about the most important risks to your retirement, read our ebook the 7 Risks of Retirement Planning.