How do you mitigate "sequence of retuns" risk early on?

[HadEnuff]

Sequence of return risk is why we have a 4% SWR "rule of thumb" instead of a 7% SWR.

4% is less than the historic average real return of a 60/40-type investment portfolio. The reason the "SWR" is less than the average expected real return is to compensate for sequence of return risk.

So the way most folks deal with sequence of return risk is to draw less from their portfolio than it's expected return.

Other ways include having a Plan B (to spend less money if a downturn occurs) and a Plan C (a way to earn some extra income if Plan B looks insufficient).

Having retired at 38, we started with a low WR (Plan A), had lots of ways of cutting costs (Plan B), and kept up some freelance gigs just to keep Plan C viable.

Now after having experienced massive equity returns for the first six years of our retirement, Plan C is kind of withering on the vine. Meanwhile, Plan A is more robust than ever. But to compensate for our loss of Plan C and to further reinforce Plan A we're now reducing our equity exposure to lower our sequence of return risk going forward.

So my view is that the way to deal with sequence of return risk and other retirement uncertainties is to construct a flexible plan with lots of levers to pull and then actively manage that plan as events unfold.

I will retire next year and my investments will need to cover 65% of my expenses first year, and rising after that. However, I have waited until my initial WR is ony 1.5% so I feel that is protection against market declines. My AA is currently 65% equities, but I will bring that down another 5-10% before RE.

Going back to work may or may not be an option depending upon age, health, and the state of the economy. Another poster on another thread made the point that the type of economic scenario that may require you to rejoin the workforce may also include a paucity of jobs. So, me, personally, I don't like to put too much faith in that one. However, I'm 62, and that's a different situation than someone retiring in their 30s or 40s.

Personally, I like the idea of waiting until you have a low SWR. I wish I could live happily on the 1.5% that DrRoy has managed. I'm more like 3.4%, along with a sensible allocation, so that I can avoid selling off equities before a recovery.

And of course, Gone4Good's Plan B, cutting costs if need be. And that's about it.

 

[Fedup]

It's much easier to cut expense. I've done that before. I'm sure that's how the term "staycation" was invented during the Great Recession.


Sent from my iPad using Early Retirement Forum

 

[mathjak107]

Sequence of return risk is why we have a 4% SWR "rule of thumb" instead of a 7% SWR.

4% is less than the historic average real return of a 60/40-type investment portfolio. The reason the "SWR" is less than the average expected real return is to compensate for sequence of return risk.

So the way most folks deal with sequence of return risk is to draw less from their portfolio than it's expected return.

Other ways include having a Plan B (to spend less money if a downturn occurs) and a Plan C (a way to earn some extra income if Plan B looks insufficient).

Having retired at 38, we started with a low WR (Plan A), had lots of ways of cutting costs (Plan B), and kept up some freelance gigs just to keep Plan C viable.

Now after having experienced massive equity returns for the first six years of our retirement, Plan C is kind of withering on the vine. Meanwhile, Plan A is more robust than ever. But to compensate for our loss of Plan C and to further reinforce Plan A we're now reducing our equity exposure to lower our sequence of return risk going forward.

So my view is that the way to deal with sequence of return risk and other retirement uncertainties is to construct a flexible plan with lots of levers to pull and then actively manage that plan as events unfold.

while the swr takes in poor sequence of returns , what it does not cover well is extended down turns early on starting day 1 which can be the most devastating .

drops like 2008 day 1 really were not a problem because the recovery was quick . but modest drops that extend out in time can do far more damage.

that is what scares me most . this is our 2nd year in retirement . year 1 already burned principal and year 2 isn't looking so hot .

 

[mathjak107]

Perhaps the bank is obligated, but you may not be able to get the money when you need it and you won't have the funds to sue them to enforce the contract so you could be SOL.

the problem with heloc's is you still have to pay to get the money .

a home is only collateral for a loan . you still need to have and be able to pay for that loan .

 

[Dawg52]

We covered our bridge income with fixed assets (CDs and I-bonds). So we didn't take market risk during the early years of heavy withdrawals.

I think the "increasing equity allocation" is a good defensive strategy. Yes, you miss out on the upside potential, but that's okay for belt-and-suspenders people like me.

Belt and suspenders guy............that's me in a nutshell when it comes to my AA. Where's my rifle?

 

[Gone4Good]

Another poster on another thread made the point that the type of economic scenario that may require you to rejoin the workforce may also include a paucity of jobs.

That may well have been me as well.

And that's why we initially kept ties to the professional world and kept a book of freelance business going even in "Retirement." Those ongoing professional relationships formed the basis of our Plan C. Without them I'd have zero faith in our ability to ramp up earnings on demand, especially when the economy is in the tank. Even with them, Plan C always seemed like our least reliable (and least desirable) option.

 

[Gone4Good]

while the swr takes in poor sequence of returns , what it does not cover well is extended down turns early on starting day 1 which can be the most devastating .

It does take that into consideration as well. But most models (or is it every model?) limit their downside case to the worst return periods in history. So if we experience something worse than that, the models basically break. If not, those bad initial return sequences are in the model too.

 

[marko]

It does take that into consideration as well. But most models (or is it every model?) limit their downside case to the worst return periods in history. So if we experience something worse than that, the models basically break. If not, those bad initial return sequences are in the model too.

So what you're saying is the FireCalc et al have already figured in a worst case scenario--including sequence risk--except for an incredibly, "once in a century" bad case (in which all bets are off).

 

[hnzw_rui]

while the swr takes in poor sequence of returns , what it does not cover well is extended down turns early on starting day 1 which can be the most devastating .

drops like 2008 day 1 really were not a problem because the recovery was quick . but modest drops that extend out in time can do far more damage.

that is what scares me most . this is our 2nd year in retirement . year 1 already burned principal and year 2 isn't looking so hot .

1966 was effectively that due to high inflation.

https://www.kitces.com/blog/how-has...he-tech-bubble-and-the-2008-financial-crisis/

 

[Gone4Good]

So what you're saying is the FireCalc et al have already figured in a worst case scenario--including sequence risk--except for an incredibly, "once in a century" bad case (in which all bets are off).

FIRECalc specifically models against actual market returns realized over the past ~130 years. Some of those years start off really badly. Those situations are therefore included in FIRECalc results.

Other calculators do things differently. Fidelity models a "down side" scenario that is not identical to anything that has ever happened in the past. It is, however, a bad "sequence of returns" scenario that roughly matches some of those worst-times in history in terms of their impact on a retiree's portfolio.

My own view is that modeling against "worst case in history" returns sounds more conservative than it actually is. For more on that, see this other thread. But that is what most retirement calculators use as the lower limit on their downside scenarios.

 

[petershk]

Since I'm kinda testing out ER right now AND the market is "high" I've been thinking about exactly this.

My conclusion is largely... you can't mitigate it outside of your own spending habits.

Why?

Because the risk is in multiple dimensions.

Cash buffer is positive if market goes down early... but negative if market goes up sharply early. Unless you keep it outside of your asset allocation... but that's no different than if you keep 4% of your equities outside of your asset allocation and if equities go up sharply you add those gains to your asset allocation.

Does that make sense?

Basically by keeping money outside of the total SWR based on total assets it creates a buffer... but it's the same thing as if you include the buffer and subsequently lower the SWR.

There's also another kind of sequence risk.

Let's say you have a cash buffer against a market crash... but the market roars while inflation goes up significantly but before the fed raises interest rates. Now the sequence risk is crushing your cash buffer without it giving you the boost in returns in the market.

The worst of all is stagflation I think. High inflation... bad marker returns. Not much is safe there. Maybe gold or something.

So protection of any kind beyond diversification choices implies perfect knowledge of the future.

So my own conclusion is to do what is simple and helps me sleep at night and I've been transitioning to that. It's really just a basic stock/fixed strategy with monthly withdrawals into a checking account.

Something that helped me a little is comparing the risk of failure with other risks. For example, lifetime risk of getting cancer is around 38%... MUCH higher than chance of portfolio failure for me...

For me personally the running out of money fear is disproportionately large relative to other things but it's pretty irrational as well so I'm trying to attack the irrationality rather than the underlying math.

Sent from my HTC One_M8 using Early Retirement Forum mobile app

 

[audreyh1]

Our "bucket", i.e. cash buffer, just keeps getting bigger and bigger, because we spend less than we withdraw. That's OK, because it just means we can spend a big chunk of it right away if we want. I would rather this than reinvest excess funds. I might feel different about reinvesting cash unspent from our budget if markets dropped dramatically.

Right now our job in retirement is to figure out how best to spend (and gift) this dough.

I don't care about a higher portfolio terminal value.

And (knock on wood) the retirement portfolio has grown enough that even a large market drop would probably mean our spending didn't exceed our withdrawal from a reduced portfolio. At such a time we might even consider not withdrawing from our portfolio if our cash situation was still pretty flush.

We use the % remaining portfolio withdrawal method which means withdrawals drop with the portfolio drops. We don't include funds (like the cash buffer) outside the retirement portfolio when calculating the withdrawal, so in effect our withdrawal rate is lower if you take into account all investable assets, which is fine by me.

I invested enough in the retirement portfolio initially that I thought it should cover our needs long term, and I wasn't interested in investing more than "I had to" in long-term investments. It's about 53% equities. We have some other (non-cash) investments outside of it, and so far we haven't counted our IRAs either when calculating the annual withdrawal. Our IRAs are 100% equities still and we expect not to draw on them for 10 years. They add another 10% to our taxable portfolio.

 

[UpAnchor]

Using buckets is mostly just mental but hey, whatever works and lets one sleep at night.

The mental side can come in pretty handy. As I retire in two months at age 64, all I need to do is "pretend" I retired 7 years ago and that the whole SOR worry is already behind me. So 55/45 and full speed ahead...

 

[audreyh1]

IMO the mental stuff/psychology is 90% of investing.

 

[nokkieny]

Say you were planning on retiring within the next 5-10 years, but theoretically could retire immediately. Is there a strategy where you could actually use a bear market as the trigger to retire strategically?

Currently the majority of my wealth is tied up in real estate, businesses and cash. So the though I keep having is I could wait until the market crashes, and then retire and start index investing.

I have a feeling there is something major I am not considering, but it my mind I see it as a great way to mitigate risk.

 

[RunningBum]

Say you were planning on retiring within the next 5-10 years, but theoretically could retire immediately. Is there a strategy where you could actually use a bear market as the trigger to retire strategically?

Currently the majority of my wealth is tied up in real estate, businesses and cash. So the though I keep having is I could wait until the market crashes, and then retire and start index investing.

I have a feeling there is something major I am not considering, but it my mind I see it as a great way to mitigate risk.

Actually calling the bottom of a bear market seems tough to do. You could bail out too early, and still hit a lot of the downside. Especially if you've ridden out a couple of smaller dips and regretted not pulling the trigger at the bottom of one of those.

Also, will the real estate and business value also drop in the bear market? Having cash on the sidelines is nice in a bear market, but maybe you didn't have it working for you in a bull market so you're missing out on gains. I always picture people like that watching the stock market go up 30, 40, 50%, and then when it drops 20% they jump on it like it's a bargain, when in reality they missed out on a lot of gains.

Some people can time the market better than me though.

 

[Gone4Good]

We use the % remaining portfolio withdrawal method which means withdrawals drop with the portfolio drops.

That is probably the only 100% successful approach to dealing with sequence of return risks. Of course it potentially requires a great deal of spending discipline and flexibility if those really nasty down market scenarios hit early in retirement.

But perhaps a % of remaining portfolio approach coupled with a hefty cash buffer outside the portfolio is the way to go.

The cash buffer gives you some insurance against having to cut spending by 30% right out of the gate if your portfolio has also dropped 30%. The cash bucket gets refilled automatically in years where your % withdrawal exceeds your needs (assuming that ever happens, which it may not).

And by adding to your cash buffer outside the portfolio in good years you automatically lean against bull markets by increasing your overall portfolio cash position. You also lean against bear markets by drawing that cash down to smooth spending.

It's not a bad plan. In fact, it's 100% failure proof provided you can manage your spending as required.

 

[Gone4Good]

IMO the mental stuff/psychology is 90% of investing.

Agree.

It's pretty close to the whole ballgame.

 

[audreyh1]

That is probably the only 100% successful approach to dealing with sequence of return risks. Of course it potentially requires a great deal of spending discipline and flexibility if those really nasty down market scenarios hit early in retirement.

But perhaps a % of remaining portfolio approach coupled with a hefty cash buffer outside the portfolio is the way to go.

The cash buffer gives you some insurance against having to cut spending by 30% right out of the gate if your portfolio has also dropped 30%. The cash bucket gets refilled automatically in years where your % withdrawal exceeds your needs (assuming that ever happens, which it may not).

And by adding to your cash buffer outside the portfolio in good years you automatically lean against bull markets by increasing your overall portfolio cash position. You also lean against bear markets by drawing that cash down to smooth spending.

It's not a bad plan. In fact, it's 100% failure proof provided you can manage your spending as required.

Yes - I adopted the cash buffer as a method for dealing with the (often maligned) income uncertainty from the % remaining portfolio approach. I sometimes view it as a way of "income smoothing". Extra builds up after flush years and can be drawn on to supplement income reductions after lean years. We also have a lot of flexibility in that a large % of our spending is discretionary, which I tend to think is very important for the early retiree. It's pretty tough to retire early if you have mostly fixed expenses and a tight budget.

It does require spending discipline in that you can't just ratchet up your spending to match income after a run of several good years. But we naturally don't do that anyway. For other personality types it might not work.

I instinctively like the idea of taking more money "off the table", i.e. out of the retirement fund, when it is higher and market valuations seem high. Maybe we'll even add a bit back if we get hit by a bad sequence of market returns. More likely we'd simply increase our equity exposure a wee bit — if we have the guts to after the traumatic experience of rebalancing in down markets.

The big psychological issue with having the cash build up outside the portfolio for me, is that is what gives me the courage to rebalance and buy more equities when things look really, really bad (like in early 2009). I found rebalancing then, and in 2002, very difficult psychologically. I did it, but it was hard!

 

[Markola]

How do you mitigate "sequence of retuns" risk early on?

IMHO, that's a really insightful exchange above between AudreyH1 and Gone-For-Good that has clarified a lot for me as an appealing way to limit SOR risk.

AudreyH1, do you use a steady SWR through up and down markets in your retirement portfolio? What % please?

Finally, do you aim for a certain number of months or years-worth of expenses in the cash buffer or some other metric that gives you comfort? Thanks.

 

[audreyh1]

IMHO, that's a really insightful exchange above between AudreyH1 and Gone-For-Good that has clarified a lot for me as an appealing way to limit SOR risk.

AudreyH1, do you use a steady SWR through up and down markets in your retirement portfolio? What % please?

Finally, do you aim for a certain number of months or years-worth of expenses in the cash buffer or some other metric that gives you comfort? Thanks.

Yes, I currently use a steady 3.5%. But that doesn't include our IRAs which we have left in 100% equities for the past several decades don't intend to touch until our 70s. Including the IRAs the withdrawal rate is around 3%, so it's pretty conservative (we're 56 and 60).

I will probably let the withdrawal rate drift higher over time once we are both in our 60s, and perhaps more aggressively when we are in our 70s, depending on how things are looking then. By 70s we will be drawing from the IRAs too (RMDs) so our rate will bump up automatically anyway. Of course we might just reinvest and/or gift that money - who knows. We have options.

I usually have at least two years of expenses set aside by each January in high yield savings and 1 year CDs. Any additional cash that has built up over the years is in various short-term instruments.

I chose the % remaining portfolio withdrawal method because I wasn't comfortable with the idea of automatically increasing my income with inflation. I prefer to let the portfolio determine how much my income might grow. Over the very long term I have a high enough equity allocation that the portfolio should keep up or exceed inflation. But in the short term, there will be ups and downs. Regardless, I prefer that the portfolio performance determine how much my income rises (on average) over time, not inflation metrics.

On the other hand, the standard SWR method means you might have a large remaining portfolio if you luck out and have a run of good market years. The % remaining portfolio will increase income faster under the "good markets" scenario, leaving a smaller terminal amount on the table - theoretically.

 

[YVRRocketSurgery]

One could refill the cash bucket only during up years.

Would you have to even refill the cash bucket since the risk we're trying to mitigate is a poor early sequence of returns? Would the bucket just be needed for at worst, a poor 2 or 3 year period during the first 10 years of retirement?

 

[audreyh1]

Would you have to even refill the cash bucket since the risk we're trying to mitigate is a poor early sequence of returns? Would the bucket just be needed for at worst, a poor 2 or 3 year period during the first 10 years of retirement?

Right.

You only need to refill the cash bucket if you need it to sleep at night later.

 

[YVRRocketSurgery]

Right.

You only need to refill the cash bucket if you need it to sleep at night later.

 

[Hermit]

The mental side can come in pretty handy. As I retire in two months at age 64, all I need to do is "pretend" I retired 7 years ago and that the whole SOR worry is already behind me. So 55/45 and full speed ahead...

I think its all about how you are looking at things. You can start SS if need be to mitigate a down market or just to help with expenses. I'm 66 and I don't worry a lot about SOR. I have an income stream and it will increase substantially when I start SS on my account. In the mean time, I withdraw less than 2%. I haven't needed to increase my withdrawal due to inflation. My allocation is close to yours.

I wonder if Audrey calculated her SWR with all her cash buckets, etc. if she would have a very low SWR. It sounds like she has a more fixed expenditure than her withdrawal method allows. I think most of us would tighten our belt somewhat in a major down market leading to the same results.