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

[MrLoco]

I have been reading up on this and have found that most experts agree that the first 5-7 years of retirement.....especially early retirement where one is living off investments until pensions and social security are taken in later years.... is the period where poor market returns could devastate a portfolio.

My wife and I are now retired and have to bridge the next 6 years until we both start our pensions at ages 63 and 62. Social security will start 4-6 years after this. So for the next 6 years it will be muni bond income as well as dividends from taxable equity funds plus a cash surplus for unexpected expenses and/or a few vacations.

We have a cash bucket (cash,CD's, ultra short bonds) that should carry us for the next 8-10 years in the event of a prolonged bear market. Problem is that this approach of not withdrawing principal from equity funds will throw off current/desired AA of 50/50. But if the stock market drops 50%....AA will be way out of whack anyway.

Other solutions would include reducing expenses. I have read about other possible scenarios of actually entering retirement with a reduced equity allocation ....say a 40/60 or even a 30/70 equity / fixed income allocation so a big drop the first few years of retirement will not devastate a portfolio. Then gradually increase your equity allocation after 5-10 years into retirement. Of course this exercise will cause one to miss out on any gains if the market shows a significant increase early in retirement.

How have you/will you handle this issue? Thank you.

 

[garyt]

I'm keeping 3 years expenses in cash. If the market drops, 3 years should give it enough time to recover before I have to sell any equities. If it doesn't recover in three years, we're all in trouble.
If I read it right, you have 8 years of expenses before you'd need to sell equities? You should be more than good.
I wouldn't worry about your AA being out of whack at this time, you can always rebalance when things get better. I'd say you have nothing to worry about.

 

[pb4uski]

I don't feel a need to fret about it too much. While our WR from ER until I start my pension and our SS is high (4-5%) I focus on the WR after these have come online (more like 2% in our case). There are levers I could pull in the event of near-term adverse investment results... dialing back on discretionary retirement expenses (vacations, dining, entertainment and the like), starting my pension earlier than planned, starting SS earlier than planned, etc. So in my case I just stick with 60/40 and rebalance opportunistically or annually.

The little thing I did was to increase liquidity.... I went from essentially 0% cash when I retired to 6% and made corresponding reduction to fixed income so I changed from 60/40/0 to 60/34/6. The cash is in an online savings account at 0.95% so there is a small total return impact (6 bps or so) but it allows me to sleep well. Between the cash and taxable account dividends we could cover our living expenses for a couple years.

I figure if the market had a decline that my withdrawals would naturally come from fixed income anyway when I rebalance.

If I was more concerned about sequence of returns risk I might have gone with carving out a cash bucket to carry us from ER to FRA and then go 60/40 with the rest which is probably pretty close to the alternative you mention of going in with a more conservative AA, taking withdrawals from fixed income and then letting the AA drift up to a more conventional AA.

 

[REWahoo]

MrLoco, you have asked the question that drives other early retirees loco as well.

We retired in 05 and had the pleasure of experiencing the 08/09 market drop in years 3 & 4 - right in the middle of that critical 5-7 year period. It appears as though we weathered it with a combination of 1) a somewhat conservative 45/45/10 AA (note the cash 'bucket' which prevented me from having to sell equities while the market was down) and 2) the gut-wrenching experience of sticking with that AA during the ride down (and back up).

As I've stated several times before, having the majority of our assets in balanced funds (Wellesley and Wellington) prevented me from having to do my own rebalancing through those turbulent years. All I had to do was hang on for the ride and hope for the best.

Of course, just because it worked then doesn't mean it will work the next time the marked takes a dive. But for now I plan to continue to dance with the gal who brung me, and stick with this strategy until there is no more money or no more me...

 

[audreyh1]

We did the cash buffer thing, as well as averaging in a lump sum at the start of retirement. If I'd known of the Kitces rising equity glide path I might have taken that approach.

Retired mid 1999, so you can see the ride we've had so far!

 

[Senator]

Have multiple income streams. I have a small VA pension (10%), a small megacorp pension ($1260), SS (~max at 62 and beyond), rental income ($14K+ a month), dividends ($2K a month).

Make sure you have a solid buffer, if the market declines, you can cut back spending. My spending is ~$40K, but I intend to ramp it up and potentially hire more help with the rentals. My income streams could also decline, even if they decline by 50%, I should be OK.

Have your bills paid off, that minimizes mandatory expenses. No mortgage helps. No car payments, no CC interest. Even my rentals are mostly paid off.

In the end, it's a leap of faith.

 

[Gone4Good]

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.

 

[Totoro]

For my mother I've used a rising equity path. She started from 0%, now she's at 30% or so. Planning to keep her there until the market drops (if ever). Then we'll move higher to 50% and stay there.

Reason is emotional: it's really hard to stay the course if a crash happens in the beginning with a substantial amount of money. Especially if one never has been in equities before. In addition certainty increases as time moves on: specifically life expectancy, pension, spending patterns etc .. It's ok if that means a lower return. Sleeping well at night is a valuable commodity

For myself roughly similar story, only I'm at roughly 45% equities now and want to move to 80%. Thanks to this forum I'm now planning on using cash covered puts to bump returns for the parked 35% until the dip comes (if and when it comes).

In parallel my individual equity portion is intended to be geared towards blue chips that tend to outperform when markets drop. Whether that'll work as intended, time will tell ..

 

[W2R]

When I was preparing for retirement, I was worried about this too - - to the extent that I just assumed I would have to endure a rotten sequence of returns during the first few years after my 2009 retirement. I had no idea if the market had finished bottoming out. After all, everyone said "This time it's different!" And I believed it.

So, what I did was:

(1) arranged to have several small income streams coming in from different sources. Tiny pension, TSP G Fund, and then SS as a last ditch option once I was old enough. I was even thinking of possibly getting an SPIA to provide another income stream, if things got bad enough, but I don't recommend that approach now because the rates are abysmal.

(2) Set up a conservative asset allocation with 45% stocks, 55% fixed

(3) Of the 55% fixed, a lot was in cash or cash equivalents, enough to cover a very long time at my 2008 spending level.

(4) Paid off the house in 2006 to lower that annual spending level, and had no car loan or other debts. Got to keep it simple.

Much to my surprise and glee, my returns were terrific during those first few years.

 

[daylatedollarshort]

is the period where poor market returns could devastate a portfolio...How have you/will you handle this issue? Thank you.

We use liability matching. Not much in stocks or potential for gain from stocks, but no big losses, either:

https://www.bogleheads.org/wiki/Matching_strategy

 

[RunningBum]

It seems to me that part of it is a factor of how many years you have to account for in retirement.

Let's say you retire at age 48. You're worried about sequence of returns early in retirement, so you invest conservatively for 7 years, and make only modest returns.

I retire 7 years later at age 55. Am I really more exposed for the next 5-7 years than you for sequence of returns, assuming reasonable close life expectancy? I think we're both at risk.

My way of overcoming it was to keep a year or so of cash so that I wouldn't have to sell after a sharp correction (and hope it recovered within a year), and enough bonds to also sell for quite a number of years if it was a prolonged downturn. I know some people hold more in cash, or a CD ladder, but I chose not to keep that much out of the market. Given bond rates, I'd have probably done better with a CD ladder. But basically, the idea is to have something to live on to avoid selling equities until the market can recover, and have faith that it will.

I also worked at least OMY, actually more, to build a comfortable cushion. I had hit my number back in 1999 but when the dotcom bubble burst I was well under it, so one lesson I learned was to have enough to survive a downturn. The other lesson was to be a lot better diversified.

I also figured, retiring at 49, that if I did hit a bad early sequence of returns, I'd have time to either adjust my spending, or even go back to work as a last resort.

 

[DrRoy]

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.

 

[Gone4Good]

If you're using a model like FIRECalc to analyze your retirement plan's surviability it's worth knowing that using "an x-years of cash strategy" to ward against market downturns doesn't enhance the outcome.

FIRECalc already assumes you'll spend from your fixed income allocation during equity market slumps. More than that, it assumes you'll sell some of your fixed income to buy equities during those slumps. That's what annual rebalancing back to a set asset allocation does by default.

So if FIRECalc says you have a 90% probability of success with a 60/40 asset allocation, holding some of that 40% in cash or a ladder to "live off of during down markets" doesn't move that needle at all. Your probability of success is still 90% assuming you plan to rebalance. And probably something less if you don't.

 

[youbet]

I'm keeping 3 years expenses in cash. If the market drops, 3 years should give it enough time to recover before I have to sell any equities. If it doesn't recover in three years, we're all in trouble.
If I read it right, you have 8 years of expenses before you'd need to sell equities? You should be more than good.
I wouldn't worry about your AA being out of whack at this time, you can always rebalance when things get better. I'd say you have nothing to worry about.

Are you saying that you're 100% equities other than 3 yrs of your expenses in cash? How does that work out in in AA percentages? Maybe 90% equities and 10% cash?

 

[hnzw_rui]

If you're using a model like FIRECalc to analyze your retirement plan's surviability it's worth knowing that using "an x-years of cash strategy" to ward against market downturns doesn't enhance the outcome.

FIRECalc already assumes you'll spend from your fixed income allocation during equity market slumps. More than that, it assumes you'll sell some of your fixed income to buy equities during those slumps. That's what annual rebalancing back to a set asset allocation does by default.

So if FIRECalc says you have a 90% probability of success with a 60/40 asset allocation, holding some of that 40% in cash or a ladder to "live off of during down markets" doesn't move that needle at all. Your probability of success is still 90% assuming you plan to rebalance. And probably something less if you don't.

That's true if a person considers the cash holdings as part of the portfolio. Some might just have 25x in 60/40 and keep am additional 3x in cash that doesn't get included in FIRECalc assets so in effect, they've actually got ~3.6% WR instead of 4%.

 

[Gone4Good]

That's true if a person considers the cash holdings as part of the portfolio. Some might just have 25x in 60/40 and additional 3x in cash so in effect, they've actually got ~3.6% WR instead of 4%.

+1

That works.

Edit to add: I guess you'd have to model out how you replace those years of cash you draw down. That would mean higher portfolio WRs at some point. Or maybe you plan to never replace them.

 

[jimbee]

That's true if a person considers the cash holdings as part of the portfolio. Some might just have 25x in 60/40 and keep am additional 3x in cash that doesn't get included in FIRECalc assets so in effect, they've actually got ~3.6% WR instead of 4%.

A person can do that, but it's like setting your clock ten minutes ahead so you're less likely to be late.

 

[Markola]

FIRECalc already assumes you'll spend from your fixed income allocation during equity market slumps. More than that, it assumes you'll sell some of your fixed income to buy equities during those slumps. That's what annual rebalancing back to a set asset allocation does by default.

Do you know how FIRECalc handles target date, target allocation, and other self-balancing funds, including Wellesley? By definition, a total return withdrawal strategy would require selling some shares across all asset classes in the fund in both upturns and downturns.

 

[Options]

My thinking was affected by Dirk Cotton's excellent series on the subject:

The Retirement Café: Clarifying Sequence of Returns Risk (Part 1)

The Retirement Café: Clarifying Sequence of Returns Risk (Part 2, with Pictures!)

The Retirement Café: The Implications of Sequence of Returns Risk

The Retirement Café: Sequence of Returns Risk or Something Else?

The Retirement Café: Sequence of Returns Risk and Payouts

we can eliminate SOR risk from terminal portfolio values, or eliminate it from annual payouts, but not both. If we eliminate it from annual payouts, we introduce the risk of portfolio failure.

By basing our spending strategy on a constant percentage of remaining portfolio values, we can shift SOR risk to annual payouts, where it seems to do less harm.

Personally, I’d prefer risking my annual income to risking the source of all future annual income, even if it were an even trade, but it is not.

Describes my comfort zone exactly. OTOH, I do not use variable percentage withdrawal. Instead, I've reduced AA to 40/60 in the early years of retirement (increasing possibly to 50/50 later TBD, based on PF values), used the LMP technique, plan to reduce withdrawals substantially in the event of extreme market volatility (vis a vis 2008), and have other buffers/cushion. In fact, as I've posted, I probably saved too much anyway so not really worried about experiencing a bad SOR (not to say I'd be happy about it).

 

[Independent]

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.

 

[hnzw_rui]

Edit to add: I guess you'd have to model out how you replace those years of cash you draw down. That would mean higher portfolio WRs at some point. Or maybe you plan to never replace them.

Unless you choose % of portfolio method, the WR in FIRECalc is only for the initial withdrawal. With the inflation adjustment component, WR as percentage of remaining portfolio will go up as time passes if returns are less than the withdrawal.

That's actually what made 1966 so difficult. Because of runaway inflation, WR after just a few years was around 10% of the portfolio.

A person can do that, but it's like setting your clock ten minutes ahead so you're less likely to be late.

My mom actually does this.

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

 

[Gone4Good]

Do you know how FIRECalc handles target date, target allocation, and other self-balancing funds, including Wellesley?

I don't think FIRECalc provisions for balanced funds. It relies on you to tell it what you're asset allocation is and then works with that.

By definition, a total return withdrawal strategy would require selling some shares across all asset classes in the fund in both upturns and downturns.

Perhaps an example will help . . .

I start with 1,000 split 60/40 between equity and debt.

Year 1: equities drop 20%, bonds are flat and I've drawn 4% from my cash position to live on. That leaves me with $480 in stocks and $360 in bonds for an equity allocation of 57.4%.

I've sold no equities during the downturn and will actually need to buy some stock to rebalance back to 60/40.

Year 2: equities go up 20%, bonds are flat, and I've drawn another $40 from cash. That leaves me with $605 in stocks, $296 in bonds for an equity allocation of 67%. Now I need to sell $64 in stocks (more than my annual withdrawal amount) to rebalance my portfolio back to 60/40.

In year one I effectively draw 100% of my cash needs from my bond portfolio. In year two I effectively draw 100% of my cash needs from the stock portfolio.

How much comes from each side depends on the relative performance of the underlying assets. That's how FIRECalc works.

 

[youbet]

+1

That works.

Edit to add: I guess you'd have to model out how you replace those years of cash you draw down. That would mean higher portfolio WRs at some point. Or maybe you plan to never replace them.

Wouldn't you just put the "outside the portfolio" cash bucket on auto-refill? Each time it approaches zero, the cash fairy squirts in a new supply!

 

[Gone4Good]

Wouldn't you just put the "outside the portfolio" cash bucket on auto-refill? Each time it approaches zero, the cash fairy squirts in a new supply!

Certainly you could do that or any of a variety of other schemes. But how you manage that bucket is going to effect how it impacts portfolio survivability.

If you're auto-refilling it when it reaches zero that means pulling a large chunk of cash out of your portfolio all at once. And because you're depleting that cash bucket during bad market times, it seems likely that you'll also be refilling it from a portfolio hit by those same bad markets. That could actually make things worse rather than better.

It's not clear to me what kind of advantage this provides over the standard rebalancing approach. Although it wouldn't surprise me if someone could model a clever strategy that seems to offer some benefit.

 

[FreeBear]

MrLoco,

What is your withdrawal rate before start of pension? In my mind this makes a big difference on your level of vulnerability to SOR.

We're at 4.5% for at least the next 5 years, then dropping to 3.5%, I hope. The 4.5% is on the outer edge of my comfort zone, so we are minding our asset allocation and actively trimming expenses.

We're at 50/38/12 (stock/bond/cash) AA. That amounts to 2.5 yrs cash (1% online savings account and short bonds). Once we get to SS and our SWR drops to 3% ish, we'll start a rising glide path towards 60% equities.

I hate holding 2+ yrs. in cash, but bond returns are poor and I like to sleep at night.

FB