Wade Pfau coined the term Buffer Assets. It is such a powerful phrase that speaks to me.
In a post, Dr. Pfau describes “Four Ways” or “Four Approaches” or “General Techniques” to Manage Sequence of Return Risk. In this context, Buffer Assets are one of the four ways, or approaches or techniques. In addition, he lists “reduce volatility” and “flexible spending.” The fourth way he describes is “spend conservatively”—however, he points out that this can actually increase sequence risk as you need to make your portfolio more aggressive to compensate.
Maybe we should get rid of spend conservatively since it actually increases sequence risk.
In fact, I propose an even larger change to Dr. Pfau’s Techniques.
I suggest defining any strategy to combat sequence of return risk a buffer asset. After all, an asset is not just an investment. Assets are also strategies, advantages, resources, or anything else you can use in defense against sequence risk.
Buffer Assets: A New Definition
So, a buffer asset is anything that can mitigate sequence of return risk. This definition is, in fact, a stretch from what Dr. Pfau intends. In my view, however, a necessary one. From an academic standpoint, the answer to the question “how do you defend against sequence risk” is: Buffer Assets.
Buffer assets provide the luxury to sell equities at your leisure. In contrast, without buffer assets, one is forced to sell stocks when they are down—or reverse dollar cost average. This is, in fact, the demon of retirement—Sequence Risk—selling low and locking in losses.
Classification of Buffer Assets
So, with great homage to Dr. Pfau, I would like to suggest the following classification system for buffer assets. This is adapted from an original system previously described.
Flexible Cashflow – reducing spending after portfolio decline is effective in mitigating sequence risk. In fact, it is also a natural behavior when the economy is in recession. Folks note what is going on around them and spend less. In addition, there is the income side of the equation
- Expense Modification: Income need is driven by expenses in retirement. One can modify spending (spend conservatively or have guiderails for spending).
- Income Generation: Depending on other income sources, using human capital (i.e. part time job or a side gig) can decrease income demands on the portfolio.
- Additional Income: Income from rentals, patents, and other passive income streams decrease the withdrawal rate from the portfolio and thus the stress from sequence risk.
Dampen Volatility—during downturns in the market, think about strategies and investments that may be less affected by the chaos.
- Volatility Ladders: “Ladders” of CDs, bonds, or MYGAs. Consider laddering a combination of 2 or 3 of these depending on interest rates.
- Planned Allocation Strategies: Rising equity glide paths or bond tents are important considerations.
- Goal Segmentation Strategies: Guaranteed fixed income “floor” provided through social security, pensions, annuities or TIPS ladder.
- Annuity Strategies: Social security claiming strategy, income from immediate annuities or longevity insurance from deferred annuities.
- Income Portfolio: Preferred stock, dividend stocks, utility stocks, REITs, convertible bonds and MLPs are not infrequently used by investors for “bond-like” exposure.
Uncorrelated Non-Portfolio Assets—these assets are not market based and therefore are less correlated (rather than non-correlated) with market returns. They can be sold or borrowed from during downturns in the market to prevent selling stocks when prices are low.
- Cash Reserve Strategies: Cash is for spending and not an effective buffer asset. I would remove this from classification.
- Classic Buffer Assets: Cash value life insurance and reverse mortgages have low correlation to market returns and tax-free “income.”
- Other Assets: Businesses, hobby collections, rental properties, or other assets can be sold to hedge against a down market.
Use of the Buffer Assets Classification System
Buffer Assets mitigate against sequence risk. Using the above classification, there are considerations for cashflow, volatility, and uncorrelated assets.
Retirement is an exercise in income creation. Rather than work to provide income, stored reserves of work (money) provide for spending. Let’s look at how the Buffer Assets interact with income generation (from de-accumulation) and sequence risk.
Cashflow is important in retirement. Again, income creation is what makes de-accumulation more difficult than accumulation. We see in the above classification system there can be a role for a part time gig to prove incoming cashflow. In addition, modification of expenses—spending less—is common and expected during cyclical downturns in the economy.
Rental income and other passive streams of income are also important considerations. This income reduces strain on the portfolio through a decrease Safe Withdrawal Rate (SWR). Even a small decrease in SWR tames sequence risk during a traditional 30-year retirement. During a prolonged retirement, a 3.25% to 3.5% SWR is more sustainable. Having passive income streams in retirement is an ideal way to reduce sequence risk.
This category has several themes.
First, decreased exposure to stocks during 5 years before to 10 years after retirement. This is the highest risk time for poor return sequences. Decreased exposure occurs via “ladders”—where you have your income needs met through timed maturation of investments. Additionally, a programmatic increase in equities once much of the risk has passed decreases exposure to sequence risk.
Second, flooring, or meeting income needs with guaranteed products such as social security and other annuities. Similar to passive income, flooring decreases the Safe Withdrawal Rate and immunizes against sequence risk.
Lastly, a segment of investors employ income portfolios to decrease volatility. Dividend investors are frequently proud of the dividends they receive from their investments. This income decreases volatility by decreasing the need to sell stocks for income.
Uncorrelated Non-Portfolio Assets
Folks have assets outside of the stock market. These assets–homes, insurance policies, businesses, hobby collections, etc.–have lower correlations with market returns. Obviously, home prices are affected by the economy. Most prices are.
Uncorrelated is perhaps not exactly the right term, but it sounds better than “less-correlated.”
A home’s equity can be used via a reverse mortgage or a home equity line of credit. Permanent life insurance provides tax free “income” via withdrawals or loans against the cash value. I call these classic buffer assets; the original buffer assets recognized by Dr. Pfau.
Other assets can be sold as needed to provide a bolus of cash and decrease the need to sell equities when they are down.
Above, I offer a new definition of buffer assets.
How does a retiree deal with sequence risk? With buffer assets. Investments, strategies and cashflow come together to prevent selling stocks when the market is down early on in retirement.
A classification system provides a framework when discussing an individual’s approach to prevent sequence risk. One size doesn’t fit all. Multiple modalities are indicated to avoid the demon of retirement.