Monday, June 27, 2016

Sequence of Returns Risk Generally Not Devastating if You Adjust Your Spending

A lot of retirement experts get pretty excited about what is commonly referred to in discussions about spending in retirement as “sequence of returns risk.”  This risk is generally the negative impact on retirement portfolios associated with spending during periods of poor investment performance.   Frequently the experts will focus on the period just after retirement when they claim this risk is highest.   For example, in his recent Forbes articles “Navigating One of the Greatest Risks of Retirement Income Planning” and Evaluating the Impact of Sequence Risk on Retirement Income”, Dr. Wade Pfau states, “Even with the same average returns over a long period of time, retiring at the start of a bear market is very dangerous; wealth can be rapidly depleted as withdrawals are made from a diminishing portfolio, leaving little money to benefit from a subsequent market recovery”;  “if negative returns are experienced when you start spending from your portfolio, you will face an insurmountable hurdle that cannot be overcome even if the market offers higher returns later in retirement” and “In the withdrawal phase of retirement, the specific sequence of market returns matters a great deal.”

I agree that the sequence of returns matters.  I’m not so sure that it matters more when you have just retired vs. when you have been retired for quite a while, but the point of this post is to show you that sequence of return risk can be mitigated by decreasing spending during unfavorable return periods.   Since the Actuarial Approach recommended in this website encourages retirees to annually determine a spending budget that matches their assets to their liabilities on a “mark to market” basis, it automatically adjusts spending budgets to mitigate or reduce sequence of returns risk.  

Let’s look at a simple example to illustrate this point.   Throughout this example, I will be using the five-year projection tab of the Actuarial Budget Calculator spreadsheet from this website.   This tab allows the user to vary future investment returns and actual spending to see the effect on retiree assets and future spending budgets.  We are going to look at a 65-year old retiree with an annual Social Security benefit of $20,000 and $500,000 of accumulated savings, no bequest motive and a desire to have future spending budgets increase with inflation.  For simplicity sake, we are going to look at our example retiree’s spending budget as a whole and not separate it into different budgets by expense type as we would normally recommend. 

If we enter the sample retiree’s data and recommended assumptions into the “input” tab of the spreadsheet, we develop a first year spending budget under the Actuarial Approach of $41,751 ($20,000 from Social Security and $21,751 from accumulated savings).  The “run-out” and “inflation-adjusted run-out” tabs of the spreadsheet are based on the assumption that the 4.5% investment return that we entered in the input tab will be exactly realized each future year.  As discussed in prior posts, this is clearly not a realistic assumption about the future, but we include these tabs simply to show that the math works.   These tabs show that if the retiree earns 4.5% each year on his assets and all the other assumptions are realized, his real dollar spending budget will remain at $41,751 each year and his accumulated savings at after five years at age 70 is expected to be $492,651 in nominal dollars ($435,432 in inflation-adjusted dollars).

With this example retiree as background, we are going to shift to the 5-year projection tab and model a different sequence of returns to see how real spending amounts and assets remaining after the five-year projection period are affected.   Instead of assuming constant 4.5% investment returns, we are going to assume the following sequence of returns:  -25%, -5%, 10%, 20% and 32.5%.  The geometric average of this sequence of returns is approximately 4.5% per annum.  So, if you had invested one dollar at the beginning of the 5-year period and didn’t make any withdrawals, you would have approximately the same amount of money ($1.246) at the end of 5 years under either the constant 4.5% return sequence or this alternative sequence.

Now we will look at the impact on spending budgets and assets at the end of the five-year projection period of using different spending approaches.   The four different spending approaches considered are:  the Actuarial Approach without Smoothing, the Actuarial Approach with Smoothing, the 4% Rule and the Guyton Decision Rules starting with a 5.5% withdrawal rate.  The Actuarial Approach without smoothing is just application of the approach recommended in this website without any smoothing of the budget or spending amount.  The Actuarial Approach with Smoothing applies the following smoothing algorithm:  Increase the prior year’s budget amount by inflation but the result must fall within 10% of this year’s calculated budget using the Actuarial Approach.  The 4% Rule takes 4% of the initial year’s accumulated savings and adds that year’s Social Security benefit.  Each year thereafter, the initial year’s amount withdrawn from savings is increased by inflation irrespective of investment return for that year.  Under the Guyton Decision Rules (discussed more in our post of April 26, 2015), the amount withdrawn from savings is increased by inflation each year, but is reduced by 10% for a year in which the current year’s withdrawal rate is more than 20% higher than the initial withdrawal rate and increased by 10% for a year in which the current year’s withdrawal rate is less than 20% below the initial withdrawal rate.  In this example, the initial withdrawal rate used was 5.5%.

click to enlarge
The graph shows that the 4% Rule produces the smoothest pattern of real dollar spending budgets for this particular example retiree.  The Actuarial Approach without smoothing produces the most year to year variation in real dollar spending.   The two smoothing approaches provide more smoothing of real dollar spending than the Actuarial Approach without Smoothing but less than the 4% Rule.  At the end of fifth year, the Actuarial Approach without Smoothing has assets of $492,644.  This amount is basically the same (off by rounding) as the assets expected ($492,651) under the 4.5% per year investment return run-out in nominal dollars.   By comparison, the end of the fifth year assets under the Actuarial Approach with smoothing is $475,758; it is $463,848 under the 4% Rule and $445,657 under the Guyton Decision Rule starting at a 5.5% withdrawal rate.   Thus, approaches that involve high initial withdrawal rates, like the Guyton Decision Rule in this example, or that don’t adjust spending, like the 4% Rule, are more sensitive to sequence of return risk.  While the Actuarial Approach without smoothing produces the most year to year variation of real dollar spending budgets, its use completely mitigates the sequence of risk problem in this particular example.

As I have indicated in previous posts, you can either smooth your spending budget or you can smooth your actual spending.  You can also spend more now and thereby increase the risk of having to spend less later.    Smoothing your spending budget or front-loading your spending can increase your sequence of return risk.  Reducing your spending after experiencing poor investment returns, as recommended under the Actuarial Approach with or without smoothing can reduce this risk.  If you use a smoothing approach to develop your spending budget, I encourage you to annually monitor the spending called for under the approach you use with that called for under the Actuarial Approach to see how far off track you may have wandered.