Born lucky? Sequence of returns risk

[Meadbh]

Once again, someone reinvents the wheel.

The perils of a big hit during the first few years of retirement was illustrated by Dory36 in 2002: FIRECalc

And described by Moshe Milevsky in 2006:

http://www.ifid.ca/pdf_newsletters/PFA_2006FEB_sequencing.pdf

But the graph in Pfau's blog post is very impressive. In fact I have printed it for future reference. It will help me decide how long I have to be careful!

 

[Lsbcal]

I wish some of these researchers would just put more effort into an even better retirement calculator. Maybe somehow open up the FIREcalc code so that it can be improved?

FIREcalc is great and IMO just needs a bit more work on the quality of its output. Unfortunately the updating does not get done. I'd even be willing to donate a small amount (along with hopefully others) to get this off dead center.

 

[aim-high]

Not FIREd yet, but my plan is to start with a 30/70 split with 37.5x desired expenses and 75x bare necessity expenses (not including social security.) Over forty years I'll adjust to a 70/30 split increasing my risk as I age. That's my plan. However, "you know what you want, you take what you get."

 

[RobLJ]

There may be other strategies that listers are using to mitigate risk in the early years of retirement. Would love to hear about them. My own personal strategy is holding five years of living expenses in assets that will not decline in value if held to maturity. Assumption is that over a five year period, it is rare to lose significantly (more than 2 - 3%) in a diversified portfolio....any thoughts out there?

I might consider using a 5 year bond ladder, if I were doing what you describe above (or actually moneymarket for the first year and a ladder for years 2-5). This could be part of your bond allocation.
I'll think this through since I'm semi-retiring in 18 months to a year. It seems an attractive option, but I"m sure I haven't thought of potential problems (most obvious company bankruptcy/default, so you probably would want to pick "safe" Dow/S&P companies if you went that route).

 

[Meadbh]

I started a 5 year GIC ladder within my corporation, about 4 years prior to ER, when interest rates were higher than they are now. Think 4.25%. The first GIC recently matured and I reinvested it for a 1 year term. If interest rates rise significantly, I may continue the ladder, but most likely I will start to invest that money in equities as the GICs mature. That should give me a rising equity glide path as the retirement risk period comes to a close.

Note: GIC = Canadian version of CD

 

[pb4uski]

OK, some numbers, first without a downturn. $1m portfolio, year 1 withdraw $40k, leaving $960k. Year 2 add 3% inflation and withdraw $41.2k, leaving $918.8k in portfolio.

What if there is 40% downturn? $1m portfolio, year 1 withdraw $40k, leaving $960k, then a 40% downturn reduces it to $576k. Year 2 blindly increase withdraw to $41.2k, so portfolio is $543.8k. Recovery happens, boosting portfolio up to $891.3k, which is $27.5k less than if downturn had not happened.

What if due to downturn the annual withdrawal is reduced to 3%? $1m portfolio, year 1 withdraw $40k, leaving $960k, then a 40% downturn reduces it to $576k. Year 2 withdraw $30k, so portfolio is $546k. Recovery happens boosting portfolio up to $910k, which is only $8.8k less than if downturn had not happened.

Cutting spending by $11.2k helps portfolio preserve $18.7k more than not cutting... so, 68% of the loss is covered by one year of cutting. To survive longer downturns, use a cash bucket so you don't need to sell portfolio holdings before they recover.

What if you rebalanced after the downturn? I'm guessing that you probably come out ahead even if you took a $41.2k withdrawal in year 2.

 

[pb4uski]

I started a 5 year GIC ladder within my corporation, about 4 years prior to ER, when interest rates were higher than they are now. Think 4.25%. The first GIC recently matured and I reinvested it for a 1 year term. If interest rates rise significantly, I may continue the ladder, but most likely I will start to invest that money in equities as the GICs mature. That should give me a rising equity glide path as the retirement risk period comes to a close.

Note: GIC = Canadian version of CD

Actually we have GICs (guaranteed investment contracts issued by insurance companies) in the US but they are not very widely used and are less popular because they are not government (FDIC) insured like CDs are.

 

[Meadbh]

Actually we have GICs (guaranteed investment contracts issued by insurance companies) in the US but they are not very widely used and are less popular because they are not government (FDIC) insured like CDs are.

I didn't know that. I learn something here every day!

In Canada, GICs up to $100,000 with a maturity of up to 5 years are insured by the Canada Deposit Insurance Corporation.

What's Covered, What's Not?

I have more than $100K in GICs so they would not all be insured, but all the GICs were issued by major Canadian banks, so the possibility of default is extremely remote.

 

[pb4uski]

Sorry to bump an old thread, but I've been thinking about sequence of returns risk lately. I wonder if it is possible to hedge against sequence of returns risk via a long-term put option on a broad based equity index and if so, what it would cost. I'm thinking of something like a 5 or 10 year put on the S&P 500 that is 10% out of the money at issue. Thoughts?

IIRC the real risk is of a down market in the early years that recovers slowly and something like the above would hedge such a risk. The notional amount would only need to be an amount equal to your equity allocation at the time you retire.

 

[ERD50]

Sorry to bump an old thread, but I've been thinking about sequence of returns risk lately. I wonder if it is possible to hedge against sequence of returns risk via a long-term put option on a broad based equity index and if so, what it would cost. I'm thinking of something like a 5 or 10 year put on the S&P 500 that is 10% out of the money at issue. Thoughts? ... .

Can you find some quotes for a 5-10 year put? I only found going out to DEC 2016, and with SPY at ~ 196, a 180 put was something like $17.

That means SPY would need to close below 163 before the put did you any good at all. And of course, you gave up $17 against the future value. And....

if it did come to pass, you'd be selling at 180, which just might be near a low - when do you get back in? Market timing!

Not sure how that would play out with the longer term puts, but I bet something similar. When I've considered this, I've generally decided the best 'hedge' is a lower AA.

-ERD50

 

[clifp]

The longest current put you can buy is the Dec 2016 on SPY and a few other stocks/indexes. A Dec 16, 175 Put (10% below) would cost you $15 or about 3.4% on annualized basis.

With VIX near record lows this is probably as good a time to buy portfolio insurance as I've seen, but it still seem fairly expensive.

 

[fh2000]

Sorry to bump an old thread, but I've been thinking about sequence of returns risk lately. I wonder if it is possible to hedge against sequence of returns risk via a long-term put option on a broad based equity index and if so, what it would cost. I'm thinking of something like a 5 or 10 year put on the S&P 500 that is 10% out of the money at issue. Thoughts?

IIRC the real risk is of a down market in the early years that recovers slowly and something like the above would hedge such a risk. The notional amount would only need to be an amount equal to your equity allocation at the time you retire.

PB,

I can only see SPY LEAP option to Dec/2016 and the 10% OTM put (175 strike) quote is currently $15 per contract. Multiplier is 100 for SPY. Total outlay is $1500 per contract.

I can not see beyond 2016. You need a special account to trade long term options? I imaging the cost will be much higher.

If you want to hedge a 1M portfolio, you would need (1,000,000 / 195*100 ) = 51 contracts. You will spend $76500 to buy all those puts to hedge for the next 2 1/2 year till Dec/2016. If S&P never goes down below 175, this premium will become wasted asset.

More experienced board members, please double check my math.

I heard that you will be better served if you short S&P 500 futures (ES) instead since futures have no time decay, but I only have very limited experience on that.

 

[pb4uski]

Good info. Thanks.

So if one had a $1 million 60/40 portfolio, then the cost of the hedge would be ~$20k a year ($76,500/2.375 years from mid Aug 2014 to Dec 2016*60%) or about 200 bps.

Let's say the 2% reasonable reflects the cost of the option on the 60% equity value. The question then becomes whether it is worth giving up 2% a year for the first 5-10 years of retirement to "insure" against sequence of returns risk. I suspect that some conservative members would make that trade-off. While I'm comfortable with the risk, it might be better than going all fixed income like some who are more conservative seem to prefer.

 

[bobafett]

I'm a newbie when it comes to hedging principles but why would you hedge an entire 1m portfolio if let's say your portfolio is 60/40 stocks to bonds.

Wouldn't that 1m portfolio hedge with SPY puts (or S&P mini shorts) be covering the uncorrelated 40% fixed income portion too?

Also, wouldn't a hedge be further complicated by the % you hold in U.S. equity vs international equity in the stocks portion?

 

[pb4uski]

Yes, you would only hedge the equity portion.

 

[clifp]

Good info. Thanks.

So if one had a $1 million 60/40 portfolio, then the cost of the hedge would be ~$20k a year ($76,500/2.375 years from mid Aug 2014 to Dec 2016*60%) or about 200 bps.

Let's say the 2% reasonable reflects the cost of the option on the 60% equity value. The question then becomes whether it is worth giving up 2% a year for the first 5-10 years of retirement to "insure" against sequence of returns risk. I suspect that some conservative members would make that trade-off. While I'm comfortable with the risk, it might be better than going all fixed income like some who are more conservative seem to prefer.

I think under normal circumstance I'd like ERD simply lower your AA. However, it today environment with bond prices arguably even more over valued than equities, it seems like a reasonable strategy. Certainly one that at macro level makes sense.

It's possible that stocks could return >50% over the next five year, but a -30 or -40% is also possible. I think bonds are very unlikely to return much over 15% and are equally likely to have -20% (all numbers real returns.)

The VIX at 13 is well below normal levels this makes portfolio insurance pretty cheap relative to historical levels.

I wonder if you could safely raise your withdrawal rate to 5 or even 6%, if we could eliminate a more than 10% loss over a 2 year period...

It seems like really interesting question for some graduate student to answer...