"Sequence of Returns Risk"

Summary

In this video, Ben Felix, Chief Investment Officer at PWL Capital, discusses the concept of sequence of returns risk in retirement and the common solutions to address it, such as asset allocation strategies and the safe withdrawal rate. He challenges conventional methods, arguing that they often worsen retirement outcomes. Felix explains how a 100% equity portfolio may outperform safer strategies and highlights the importance of flexible spending, or amortization-based withdrawals, to manage sequence of returns risk. The video emphasizes adjusting spending based on market conditions for better long-term outcomes and sustainable retirement income.

Takeaways

• 😀 Sequence of returns risk refers to the danger of negative returns early in retirement, which can deplete retirement savings due to withdrawals made during market downturns.
• 😀 Different sequences of returns can lead to drastically different retirement outcomes, even if the average return is the same (e.g., one person runs out of money early while the other does not).
• 😀 Asset allocation strategies like increasing bond allocation or using a cash wedge (bucket strategy) can often be detrimental to long-term retirement outcomes.
• 😀 Historically, stocks have tended to perform better than bonds and cash over long periods, despite their volatility, making them a better option for long-term investors with real liabilities.
• 😀 The sequence of returns risk can actually be more of a problem for cash and bonds than for stocks due to inflation eroding their purchasing power over time.
• 😀 Studies on retirement glide paths (strategies that adjust asset allocation over time) show that static asset allocations, particularly those that are stock-heavy, often have the best retirement outcomes.
• 😀 The 4% withdrawal rule, popularized by William Bengen, is commonly used to determine safe retirement withdrawals but may not be as safe as originally thought, especially in volatile market conditions.
• 😀 Amortization-based withdrawal strategies, which adjust the withdrawal amount based on portfolio performance, can better manage sequence of returns risk by responding to market conditions.
• 😀 Flexible spending strategies (like amortization-based withdrawals) allow retirees to adjust their withdrawals in response to market conditions, helping reduce the risk of running out of money.
• 😀 Historical data supports that 100% equity portfolios, despite their volatility, tend to have a lower probability of failure compared to more conservative portfolios like the 60/40 stock/bond allocation.
• 😀 The key to managing sequence of returns risk is not just asset allocation, but also adopting a flexible spending strategy that adjusts withdrawals according to market performance and remaining time horizon.

Q & A

What is sequence of returns risk in retirement?

Sequence of returns risk refers to the risk of a series of negative returns early in retirement that, combined with withdrawals, can significantly deplete a portfolio and prevent it from funding future spending needs.

How can sequence of returns risk impact retirement savings?

When a portfolio experiences significant declines early in retirement, withdrawals made during this time can leave less capital to recover later, potentially running out of money earlier than expected, even if overall returns recover.

Why is sequence of returns risk typically associated with stocks?

Stocks are seen as volatile and risky, and retirees may fear the negative effects of stock market downturns on their savings. However, the risk associated with sequence of returns is often overstated when it comes to stocks, and other asset classes like bonds and cash can be more risky in the long term.

What are the issues with common asset allocation strategies like Glide paths and cash wedges?

Glide paths and cash wedges often do not solve sequence of returns risk effectively. These strategies rely on increasing bond allocations or setting aside cash for downturns, but they can leave retirees exposed to inflation and low returns, making them suboptimal for long-term success.

What are the problems with safe withdrawal rates, such as the 4% rule?

The 4% rule can result in overly conservative spending during good market years, and it doesn't adjust for market conditions or portfolio performance. In scenarios with poor returns early in retirement, this rigid rule can lead to premature depletion of retirement funds.

How does the bucket strategy work, and why is it suboptimal?

The bucket strategy involves setting aside cash to cover a few years of living expenses during market downturns, while the rest of the portfolio is invested in riskier assets. However, research shows it underperforms compared to static stock-heavy allocations, making it less effective in managing sequence of returns risk.

What is an amortization-based spending strategy, and how does it help with sequence of returns risk?

An amortization-based spending strategy calculates a sustainable annual withdrawal amount based on expected returns, remaining time horizon, and portfolio value. This flexible strategy adapts spending to market conditions, reducing the risk of running out of money during bad returns and allowing for increased spending in good times.

How does flexible spending reduce the impact of bad market conditions?

Flexible spending reduces withdrawals during market downturns, thus preserving capital for future years when the market may recover. By adjusting the spending each year based on portfolio performance, it prevents catastrophic depletion while maintaining reasonable spending levels.

What is the impact of holding an all-equity portfolio during retirement?

An all-equity portfolio has historically offered lower failure rates compared to more conservative strategies. While it can be volatile, it tends to provide better long-term growth and downside protection than bond-heavy portfolios or those with a glide path, especially when paired with flexible spending strategies.

Why is sequence of returns risk better described as sequence of withdrawals risk?

Sequence of returns risk is often the result of making constant, inflation-adjusted withdrawals from a portfolio regardless of market conditions. By adjusting withdrawals based on portfolio performance, retirees can better manage risk and improve their chances of sustaining their spending over time.