"Sequence of Returns Risk"

Key Concepts

• Sequence of Returns Risk: The risk of experiencing a series of negative investment returns early in retirement, which can severely damage the long-term viability of retirement savings due to ongoing withdrawals.
• Glide Path: A strategy where an investor gradually shifts their asset allocation from a higher equity exposure to a more conservative bond-heavy portfolio as they approach and enter retirement.
• Cash Wedge/Bucket Strategy: Holding a portion of retirement assets in cash or highly liquid investments to cover living expenses for a few years, intended to avoid selling riskier assets during market downturns.
• Safe Withdrawal Rate (SWR): A rule, most famously the 4% rule, that suggests an initial withdrawal amount from a retirement portfolio, adjusted for inflation annually, that has a high probability of lasting for a specified retirement period (e.g., 30 years).
• Amortization-Based Spending/Flexible Spending: A withdrawal strategy where the amount withdrawn each year is recalculated based on the current portfolio value, expected returns, and remaining time horizon, allowing spending to fluctuate with market conditions.
• Real Returns: Investment returns adjusted for inflation, reflecting the actual increase in purchasing power.
• Nominal Bonds: Bonds that pay a fixed interest rate, with their purchasing power subject to inflation.
• Mental Accounting: A behavioral bias where individuals treat money differently depending on its source or intended use, often leading to suboptimal financial decisions.
• Block Bootstrap: A statistical method used to simulate hypothetical data from historical data, allowing for the creation of numerous simulated investor life cycles.

Sequence of Returns Risk: A Re-evaluation

This video challenges the conventional understanding and mitigation strategies for sequence of returns risk, arguing that common approaches may be detrimental and that simpler, more effective solutions exist. The presenter, Ben Felix, Chief Investment Officer at PWL Capital, posits that sequence of returns risk, while real, is often overblown, and attempts to manage it through asset allocation gymnastics or overly conservative withdrawal rates can do more harm than good.

The Problem Illustrated: Alex vs. Jamie

To illustrate sequence of returns risk, an example is presented involving two retirees, Alex and Jamie, each starting with $1 million and expecting a 4% real annualized return over 30 years, with annual inflation-adjusted spending of $50,000.

• Alex: Experiences a negative return of -1% for the first five years, followed by over 20% for the next five years, and then 4% thereafter. Despite achieving the same average 4% annualized return as Jamie over the full period, Alex's portfolio falls short of spending targets by year 25 and runs out of money in year 26.
• Jamie: Experiences the inverse sequence: over 20% returns for the first five years, followed by -1% for the next five years, and then 4% thereafter. Jamie maintains a sizable portfolio by year 30.

This stark contrast highlights how early negative returns, combined with persistent withdrawals, can deplete a portfolio even when strong recoveries follow, leading to materially different retirement outcomes despite identical average returns.

Critiquing Conventional Asset Allocation Solutions

Common strategies to mitigate sequence of returns risk, such as increasing bond allocation (Glide Path) or holding cash (Cash Wedge/Bucket Strategy), are argued to be detrimental to long-term retirement outcomes.

• The Counterintuitive Risk of Cash and Bonds: The presenter argues that catastrophic real losses (loss of purchasing power) are historically more common in cash and bonds than in stocks. While stocks are volatile, their higher expected returns historically outpace inflation and they tend to recover after crashes. Cash and nominal bonds, with lower expected returns, can be decimated by inflation and lack the same recovery tendency. From the perspective of a long-term investor with real liabilities (like living expenses), cash and bonds can be riskier than stocks.
• Research Findings on Glide Paths:
  • "The Retirement Glide Path: An International Perspective" (2016): This study analyzed retirement Glide path strategies across 19 countries over 110 years (1900-2009) with a 4% initial withdrawal rate for 30 years. It found that static strategies (constant asset allocation) generally had the lowest failure rates, highest expected returns, and best downside protection. A static strategy fully invested in stocks demonstrated the lowest failure rate, performed reasonably well during tail risks, and offered significantly higher upside potential. The study concluded that sequence of returns risk, while theoretically plausible, was not a key determinant of portfolio failure in their broad global sample.
  • "Beyond the Status Quo: A Critical Assessment of Life Cycle Investment Advice" (2024): This paper used block bootstrap to simulate 1 million investor life cycles for an American couple following the 4% rule, drawing on data from 39 developed countries since 1890. The authors identified an optimal 100% equity portfolio (33% domestic, 67% international stocks) as superior to strategies like a 60% stock/40% bond portfolio or a target-date fund with a decreasing equity Glide path. The all-equity portfolio had a lower probability of running out of money. Interestingly, when flexible spending was allowed, the optimal portfolio shifted away from an initial cash allocation.

Critiquing the Bucket Approach

The bucket approach, or cash wedge, is also examined and found to be suboptimal.

• "The Bucket Approach for Retirement: A Suboptimal Behavioral Trick" (2019): This paper tested a two-bucket strategy (two years of cash in one, stocks in the other) against various static stock/bond allocations for a 30-year retirement with a 4% withdrawal rule. The findings indicated that static strategies outperformed the bucket strategies across multiple performance metrics. While appealing psychologically, the bucket approach does not improve historical outcomes.

Rethinking Withdrawal Strategies: The Limitations of Safe Withdrawal Rates

The video then shifts focus to withdrawal strategies, highlighting the limitations of safe withdrawal rates (SWRs), particularly the 4% rule.

• The 4% Rule: Developed by William Bengen in 1994, it suggests an initial withdrawal amount adjusted for inflation annually, with a high probability of not exhausting a portfolio over 30 years based on U.S. historical data.
• Problems with SWRs:
  • Rigidity: SWRs do not adjust to market conditions. In a scenario like Alex's bad sequence of returns, a fixed withdrawal can lead to premature portfolio depletion.
  • Overly Conservative Spending: SWRs often result in overly conservative spending levels to ensure longevity, leaving retirees with significant unspent capital at the end of their lives, especially in good return sequences.
  • U.S.-Centric Analysis: Bengen's analysis was based on U.S. historical data, which may not be universally applicable.
• Merton's Amortization Approach: Robert Merton's earlier work proposed an optimal consumption strategy using an amortization method. This method calculates the sustainable withdrawal amount for each year based on the portfolio's expected return, remaining periods, and current portfolio value.

Amortization-Based Spending: A Flexible Solution

Amortization-based spending, or flexible spending, is presented as a superior alternative to rigid SWRs.

• How it Works: In each year, the withdrawal amount is recalculated. This allows spending to decrease after poor returns and increase after good returns.
• Benefits:
  • Mitigates Sequence of Returns Risk: By reducing withdrawals during downturns, it lessens the strain on the portfolio, preventing catastrophic depletion.
  • Increases Lifetime Spending: In good market conditions, spending can increase, leading to a higher overall standard of living throughout retirement.
  • Addresses Over-Saving: It prevents the accumulation of excessive wealth by allowing for higher spending when possible.
• Research Support: The "Beyond the Status Quo" paper found that when flexible spending was incorporated, the need for an initial cash allocation disappeared from the optimal portfolio. This suggests that sequence of returns risk can be effectively managed through spending adjustments rather than asset allocation.
• "Sequence of Withdrawals Risk": The presenter suggests that sequence of returns risk might be better termed "sequence of withdrawals risk," as returns are uncontrollable, but withdrawal decisions are choices that can significantly impact portfolio longevity.

Personal Model Findings

The presenter built a model using global stock data back to 1900 and found:

• 3.2% SWR with 0% Failure Rate: In the worst 30-year period (starting 1913), a retiree could spend 3.2% of their portfolio in the first year, adjusted for inflation, without running out of money.
• 3.65% Average Annual Spending with Amortization: Using amortization-based withdrawals in the same data, sustained average annual spending of 3.65% of the starting portfolio value was possible without running out of money, but this required spending adjustments. Sharp cuts were made early on, with spending increasing over time.

It's noted that under the conservative 3.2% SWR, adjustments wouldn't be made if returns weren't the absolute worst in history, whereas amortization-based spending would allow for upward adjustments.

Behavioral Considerations and Conclusion

While static, equity-heavy portfolios have performed well historically, they can present behavioral challenges. Asset allocation decisions should not be made lightly.

• Psychological Comfort vs. Statistical Optimality: Holding some cash, even if statistically suboptimal, might be acceptable if it provides retirees with greater comfort and confidence in their retirement plan. Individual optimality differs from statistical optimality.
• Flexible Spending as the Key: The most effective way to address sequence of returns risk is through flexible spending strategies like amortization-based withdrawals. This approach adjusts spending to market conditions and the remaining retirement period, leading to increased total spending and a decreased risk of running out of money.

In conclusion, sequence of returns risk is a genuine concern, but conventional asset allocation solutions like Glide Paths and cash buckets are often counterproductive. The most effective strategy lies in adopting flexible spending approaches that adapt to market fluctuations, thereby transforming sequence of returns risk into manageable periodic spending adjustments.