Friday, September 27, 2013

Sequence of Returns Risk or Something Else?

I've read many columns and papers about how devastating large losses can be to a portfolio when those losses occur early in retirement. Usually, this risk is referred to as Sequence of Returns (SOR) risk and it is illustrated by showing a few market returns and how they provide the same ultimate portfolio value no matter how they are ordered. Then, the column shows how the order becomes significant when we buy or sell stocks periodically from the portfolio. 

Hopefully, you followed my explanation in my two previous posts, Clarifying Sequence of Returns Risk Parts One and Two.

I agree that large losses early in retirement can be potentially devastating, and that SOR risk is introduced when an investor withdraws constant-dollar amounts from a retirement portfolio. I just don't see them as the same thing.

Let’s imagine two workers who retired on October 1, 2007, each with a 100% stock portfolio worth a million dollars. One plans to spend $45,000 every year from his portfolio. The other plans to buy a fixed annuity with the entirety of his portfolio sometime in the next month. As I explained in previous posts, the constant-withdrawal retiree is exposed to sequence of returns (SOR) risk. The fixed annuity buyer obviously is not.

From October 8, 2007 to March 2 2009, the S&P 500 fell nearly 55% in just 16 months. Our two retiree-investors are both now looking at portfolios worth about $450,000 and I would argue that, despite having different spending strategies, they are about equally screwed.

The risk of the sequence of future returns is of no consequence to the annuity buyer and for the constant-dollar spender, SOR risk will seem like a minor annoyance compared to his recent loss of more than half his portfolio.

Their problem is clearly not Sequence of Returns risk as I have discussed it.

I see their problem as having made an extremely large bet on stocks at the riskiest time in retirement and I refer to it as "early loss" risk.

The bet is extremely large because the typical pattern for a retiree-investor results having his or her their largest portfolio value just before and just after retirement. The following graph shows portfolio value for a worker who invests $6,000 a year while working, and spends $50,000 a year in retirement with a constant 8% rate of return. Even with significant changes to portfolio allocation, the worker will make his largest bets on the stock market (i.e., have the largest portfolio to invest) in the decade before and the decade after retirement.
Why is early retirement the riskiest time? Ignoring the size of the annual bet, which is in and of itself an increased risk, portfolio values in the decades before and after retirement have the greatest impact on terminal portfolio value.

Here’s a simple example. Assume that a retiree can earn 5% every year of a 30-year retirement with no risk and will spend $43,0001 each year. I replaced the 5% gain with a 30% loss in the first year of retirement, then moved the 30% loss to the second year, etc. To be clear, each scenario contains just one 30% loss and 29 five percent gains, with the loss marching through the years.

A 30% loss in the first year of retirement left only $24,000 in the terminal portfolio. The same 30% loss in year 30 leaves over $962,000.

With no losses, the portfolio would have ended with a value of nearly $1.5M. As you can see from this simple demonstration, the earlier in retirement a major loss occurs, the greater the impact on future wealth.

A 30% loss in year one had 25 times the impact of a loss in year thirty when comparing TPV’s.

(Wade Pfau posted a similar analysis today. He uses maximum sustainable withdrawal rates, instead, but comes to the same conclusion.)

So, put these two charts together and you see that the typical retiree will place her biggest stock market bet at the riskiest possible time.

That’s why I refer to this as “early loss risk” instead of SOR risk and why I see it differently than the SOR risk I have explored in my past few posts.

The obvious solution to this problem is to lower stock allocations early in retirement and perhaps increase your allocation as early loss risk eases2. That is exactly what Wade Pfau and Michael Kitces recently proposed.

To some extent, the differences between “my” SOR risk and SWR advocates’ SOR risk is semantic. They’re saying that if you implement a constant-dollar withdrawal strategy and have losses early in retirement you’re in deep doodoo. I’m saying that a large early loss is bad no matter what your spending strategy.

In a more important way, they're different. Large early losses with a constant-dollar spending strategy frequently result in the retiree going broke, while losses with a strategy based on a proportion of remaining portfolio balance threaten the retiree’s annual income, while allowing her portfolio to survive.

Either way, if you hold most of your wealth in stocks early in retirement, you have enormous risk, as many recent retirees and near-retirees learned in 2007. I was one of those, and it gave me an entirely new perspective on stock market risk.

I held 40% stocks at the market peak in 2007. I recently advised a friend to hold 20% or less.

It certainly changed my idea of “conservative allocation”.

In my next post, "Sequence of Returns Risk: What's That Mean", I'll tie up a few loose ends on this topic.

1 I reduced this from $45,000 to avoid portfolio failure in less than 30 years for the worst case.

2 It never goes away. Whatever your current age in retirement is the riskiest investment year of the rest of your life.


  1. Dirk

    If you re advising ur friend to have a 20% stock allocation! would u also advise them to follow Kitces and Pfau's increasing stock glide path?



  2. Probably.

    In fact, I sent my friend a link to their paper. But here's an important caveat that Wade emailed to me.

    "An important point of the glidepath is that it is our idea for a default glidepath, and of course individuals who are paying attention may want vary for other reasons more connected to their goals."

    So, whether and to what extent my friend chooses to increase his stock holdings over time should depend on his individual situation.

    As my blog shows, he will have less risk in the future, so it would seem reasonable.

    I personally take a different approach, and one that I have also suggested to my friend. I have the capital I need to generate income to cover non-discretionary expenses in a safe bond portfolio. I invest what I have left over in a buy-and-hold stock portfolio (no SOR risk).

    I've been retired for nearly a decade and I still hold between 20% and 30% stocks.

    1. Thank you Dirk.

      Can you elaborate on what kinds of bond portfolio you have/recommend? Treasuries, Corporates,Munis? Do you hold bond funds or a ladder?

      Thanks so much


    2. Brian, I am by no means a bond expert but I do have some guidelines that I use personally.

      First, short term bond and money market returns are pitifully low right now because the Fed is keeping them that way. Eventually, things will go back to normal, but for now, there isn't a good alternative.

      Long bonds act like stocks, so I limit myself to short-intermediate durations (5-7 years). You don't get adequate compensation for long bonds.

      My largest holding is short-intermediate TIPs bonds. I also have a few managed funds, like PIMCO Total Return, though I'm not convinced management adds much.

      Primarily I'd suggest muni's in a non-retirement account and Treasuries if held in a tax-deferred account.

      Unless you have a lot to invest and can buy several bonds, you're probably going to need a fund.

      Someone at Vanguard wrote a paper several years ago showing that bond funds aren't at a disadvantage to ladders if you don't have a specific target date in mind. In other words, if you're saving for college, individual bonds with that maturity date are a good idea. If you're just using bonds for diversity, funds are just as good-- when rates go up, bond values will go down with the fund, but you'll get the higher rate of return on the interest.

      Hope that helps. Oh, and check out some of Bernstein's books on the topic, like The Intelligent Asset Allocator.

      Good luck!