Sooner or later during retirement planning you’ll hear about the dreaded sequence-of-returns risk. In an ideal world your investments would generate large returns with zero risk. But in the real world there’s always a trade-off between high returns with high risk and low returns with low risk. To fund your retirement you have to decide on an acceptable level of risk. When you start drawing down your retirement funds, you’ll keep your fingers crossed that the market will be kind to you.
You may have calculated that your chances of running out of money are low. Perhaps you’re following the 4% rule. But if there’s a severe downturn in the early years of your retirement, constant withdrawals may deplete your funds too much to recover. Let’s look at some of the strategies for mitigating against this risk.
Spending less
It’s obvious really. If you spend less then it will reduce your chances of running out of money. In other words, sequence-of-returns risk goes up the more you spend. But trying to eliminate all risk may reduce your spending to too low a level. What’s more, by assuming the worst case scenario there’s a good chance you’ll be spending less than you can afford.
The problem lies with being inflexible in your spending. If you decide on a fixed level of discretionary spending for all time today, by the time the future arrives you’re more likely to have under-spent than over-spent. But by opting for a higher starting level, you increase the risk of running out of money.
Reducing investment risk
As we’ve seen, sequence-of-returns risk arises because investments are risky. So why not invest in less risky assets? Remember that less risk means less returns, at least on average. So this means you’ll have less to spend.
You can eliminate virtually all risk by investing in index-linked annuities. However unless you’ve already reached a ripe old age you’ll find the returns rather measly. And of course there may be nothing left to leave to your heirs should that be important to you.
Using a bucket strategy
The bucket strategy is specifically designed to deal with sequence-of-returns risk. In summary, you split your retirement fund into two or more ‘buckets’. Each bucket has a different risk/return profile. You can then withdraw from the less risky buckets should the more risky ones under-perform. The hope is that the under-performing buckets will eventually make up their losses.
The only tangible benefit of the bucket strategy is psychological in that it can provide more peace of mind. In financial terms it’s actually no better than having a suitably balanced portfolio in a single bucket, with periodic rebalancing. However the psychological benefits are certainly valuable. For this reason many financial advisors advocate this approach.
Spending flexibly
The most effective way to manage sequence-of-returns risk is to be flexible in your spending. As a simplistic example, suppose you only spent a fixed percentage of your retirement fund each year; then you’d never run out of money, no matter how long you lived. But everyone has a minimum set of expenses, so you might still end up broke.
A more sensible approach is to recognise that you’ll always need to spend on your essentials. But you can still be flexible on your discretionary spending. The question is, when should you flex discretionary spending, and by how much?
The approach we’ve adopted at EvolveMyRetirement® is to provide the user with the choice between:
- Assuming discretionary spending is always increased with inflation, or
- Allowing the app to flex discretionary spending according to financial performance.
Assume the user chooses the latter. The app first establishes a benchmark against which to measure financial performance. Then every time the app makes a projection based on uncertain variables, it measures the over- or under-performance. Based on this it flexes what would otherwise have been the inflation-adjusted discretionary spending. Based on this approach, EvolveMyRetirement® is able to reduce lifetime risk.
The sequence-of-returns trade-off
Just as there’s a trade-off between risk and return when investing, there’s a corresponding trade-off between risk and consistency when spending in drawdown. If you want a constant standard of living then you need to take more risk than if you’re willing to be flexible.
You need to get this trade-off right to overcome sequence-of-returns risk.