Kitces: The best way to manage sequence risk
Sequence of return risk truly cuts both ways. While a bad sequence coupled with ongoing withdrawals can catastrophically deplete a portfolio, a good sequence can compound the portfolio to such a degree that substantial excess wealth accrues. In fact, owing to how long-term returns compound to the upside, favorable sequences can produce far more excess wealth than unfavorable sequences produce to the downside.
How should retirees combat risk not just to the downside, but to the often-overlooked upside? In short, they need to be equipped with spending strategies that can flex to accommodate changing market conditions and set clear guardrails around spending — namely, when to cut spending in a bad sequence, and potentially when to raise it in a more favorable one. But for that to happen, some baselines need to first be established.
Long-term rates of return on a balanced portfolio suggest that investors should be able to spend at least 6% of their starting account balance in retirement, adjust their spending each year for 3% inflation and still be able to maintain their spending levels for 30 years.
After all, since the 1920s the return on an annually rebalancing 60/40 portfolio of simply large-cap U.S. stocks and intermediate government bonds is upward of 8%. That leaves more than enough room for annual inflation adjustments without risk of depleting the portfolio. As the chart below demonstrates, even after 30 years of inflation the bulk of the principal would still be left over if taking a 6% initial withdrawal rate against a portfolio with an 8% long-term return.
The chart below shows how difficult it may be to achieve returns comparable to the historical average for those retiring in today’s atmosphere of below-average bond yields and high stock valuations, yet even if we look at the worst 30-year returns for a balanced portfolio — a 6.28% compound annual growth rate for someone starting in 1929 — an investor could still sustain an initial withdrawal rate of almost 5.4% and just barely run out of money at the end of the 30th year.
The caveat, however, is the phenomenon of sequence of return risk, which reveals that even if returns average out in the long run, that doesn’t necessarily mean the portfolio can sustain ongoing withdrawals amid volatile returns. Consequently, even though an initial withdrawal rate of 6% works with long-term average returns and a 5.4% initial withdrawal rate still works with the lowest 30-year growth rate for a balanced portfolio, in practice those withdrawal rates have a remarkably high risk of failure.
In fact, as the chart below shows, using even a 5% initial withdrawal rate and adjusting spending for inflation in each subsequent year actually drains the portfolio in nearly 25% of historical scenarios. That’s even though a higher, 5.4% withdrawal rate worked when projecting the lowest 30-year average returns in history.
Accordingly, to survive the potential bad sequences that have occurred in history, it’s necessary to take out just 4% of the initial account balance, while adjusting the spending in subsequent years for inflation, to ensure the retirement portfolio survives to the end.
It’s notable that there is actually little connection between the 30-year return of the 60/40 rebalanced portfolio and the sustainable initial withdrawal rate itself. As while the safe withdrawal rate of just over 4% held for a 1966 retiree, the 30-year compound annual growth rate for that same retiree was actually 9.56% per year. By contrast, a 1937 retiree also faced a safe initial withdrawal rate of just over 4% but had a 30-year return of only 7.24%. And though a 1912 retiree had a 30-year compound growth rate of only 5.5% on a 60/40 annually rebalanced portfolio, they were still able to sustain a higher, 4.6% withdrawal rate.
Simply put, the sustainability of portfolio withdrawals is driven far more by the sequence of returns than the actual long-term return itself. To further drive home the point, returns anywhere between 5.5% and 9.5% necessitated the same 4% safe withdrawal rate, yet an 1874 retiree who saw only a 5.96% 30-year return was able to sustain a safe withdrawal rate of over 9.2%.
That return sequences can be so unfavorable is precisely why it’s not safe to withdraw at a 6% initial rate, even though the average historical return on a balanced portfolio may be nearly 8%. In essence, an unfavorable sequence of returns could happen, meaning that the retiree must withdraw far less to be safe. Thus, the evolution of the 4% safe withdrawal rate, which has proven low enough to have worked in 100% of available historical scenarios.
That said, by withdrawing at just a 4% rate, the overwhelming majority of retirees finish with a massive amount of leftover assets.
On average a 4% initial withdrawal rate results in the retiree finishing with nearly triple the original principal, on top of sustaining an initial withdrawal rate of 4% adjusted annually for inflation. In only 10% of the scenarios does the retiree even finish with less than 100% of their starting principal — and in only one of those scenarios does the final value run all the way down to zero — which of course is what defines the 4% initial withdrawal as safe in the first place.
By contrast, while the retiree has only a 10% chance of finishing with less than 100% of their starting principal, they have an equal chance of finishing with more than six times their starting principal as well.
The retiree who begins with $1 million in a portfolio and a 4% initial withdrawal rate is equally likely to finish after 30 years with less than $1 million or more than $6 million. And just as the portfolio winds down to $0 in the one worst scenario, it also finishes at more than $9 million in the one best.
So while sequence of returns risk brings the potential for significant downside for a retiree who may have otherwise had reasonable long-term returns but generated them in an unfavorable sequence, it also has substantial upside potential too.
DYNAMIC SPENDING MODELS
While sequence of returns risk can cut to the downside and the upside, the irony is that due to the compounding nature of wealth, a good sequence can produce exponentially more wealth to the upside than the bad scenarios produce to the downside.
As previously noted, a $1 million portfolio has an equal probability to finish at the same level of principal or $6 million. Even at a 5% initial withdrawal rate, the 25% chance of depleting the portfolio that advisors might caution clients about is the same as the 25% chance of finishing with nearly triple the original principal instead — on top of that 5% initial withdrawal rate with a lifetime of inflation adjustments.
An advisor’s natural tendency is to advocate spending at levels that the portfolio can sustain — i.e., the “we’ll deal with any upside later” approach. This isn’t the worst strategic approach to retirement planning, as it both avoids or at least reduces the risk that an advisor is ever sued if/when a heavily spending client gets a bad sequence and runs out of money, and it aligns well to most people’s spending habits. It’s far more traumatic to cut back on spending in a bad sequence than to simply increase it in a good one.
Nonetheless, the key point remains that dialing down spending to manage sequence of return risk almost always produces excess wealth, and in favorable sequences can produce dramatic levels of it. Meanwhile, a low withdrawal rate may preserve principal in bad sequences, but it’s equally likely to increase principal by three or even six times in a favorable sequence.
This raises interesting questions about whether advisors — saying nothing of retirees — focus too much on the downside risk, and not enough on the equal upside and consequent risk of underspending retirement assets. There may simply be too much focus on setting a low enough withdrawal rate to be safe, instead of trying to determine the best approach to dynamically adjust spending along the way.
One tactic for handling the situation is simply to use a so-called ratcheting rule, where spending is ratcheted higher if and when a favorable sequence occurs. For instance, the retiree might start with a 4% initial withdrawal rate, but with a plan to increase spending by 10% any time the current portfolio is up at least 50% from its starting point, to be revisited every three years. In good sequences spending will rise to consume the otherwise excess assets, but in bad sequences spending is low enough to sustain.
Another dynamic spending approach would be a version of Guyton’s guardrails, where the portfolio’s current withdrawal rate is monitored on an ongoing basis and adjustments made if/when certain critical thresholds are breached. For instance, a retiree may use an initial withdrawal rate of 5%, but if the ongoing withdrawals relative to the portfolio rise above 6% then spending would be cut because spending is dangerously outpacing portfolio growth. Meanwhile, if the withdrawal rate falls below 4% — as portfolio growth outpaces spending growth — then the retiree would get a spending increase. The end result is a spending rate that adjusts dynamically as the sequence unfolds, with the potential for cuts if the sequence is unfavorable but also the potential for bumps if the sequence turns out to be more positive.
Unfortunately, modern retirement planning software is very limited in its ability to model such dynamic spending strategies, with only a few emerging solutions that can help illustrate the benefits of planning in advance for making at least some mid-course spending adjustments.
Regardless of the particular dynamic spending approach, the key is simply to recognize that because sequence of return risk cuts both ways, conservative spending strategies to manage worst-case sequences can leave absolutely stunning amounts of excess wealth in a favorable — or even merely not horrible — sequence. This means at a minimum, some strategy should be considered.
It’s admittedly not a terrible outcome to simply be surprised by the upside of wealth. But given retirees naturally tend to decrease their spending, without a plan for favorable sequences of returns there’s a material risk that by the time the retiree realizes they’re on a favorable path, there won’t be enough time and opportunity to enjoy it.
Stated more simply: If an initial withdrawal rate of 5% has an equal likelihood of running out of money or tripling in value over the span of retirement, does it still seem too risky? Or is it less about the risk itself and more about simply having a plan to make adjustments — for the potential of either good or bad sequences — along the way? Our perspective and expertise in this realm is yet another way we can provide value to the client relationship.