How to Mitigate Sequence Risk.
How do you mitigate your portfolio against sequence risk?
As we know, sequence risk is one of the largest risks someone new to retirement faces. In fact, this risk starts 5-10 years before retirement!
Further, we all know about the 4% rule. The purpose of this infamous withdrawal strategy IS TO mitigate sequence of withdrawal risk. Beginning with this (quite) low inflation adjusted withdrawal rate, you outlive your money most of the time when using historical equity and fixed income returns.
Let’s look at all the different ways you can mitigate sequence risk and then focus in on a classification scheme Next, let’s seem some examples of sequence risk mitigation in action.
Different Strategies to Mitigate Sequence Risk
What are the strategies to mitigate sequence risk?
In a post, Dr. Pfau describes “Four Ways,” “Approaches” or “General Techniques” to Manage Sequence Risk. He lists reduce volatility, spend conservatively and flexible spending as three ways. Finally, he describes buffer assets as the fourth way.
Two of the four are about reduced spending (such as the 4% rule), and the other is an attempt to reduce the volatility of the portfolio. The reduction in volatility means less time with a negative portfolio from which to potentially withdrawal.
Buffer assets are an interesting concept. These assets are non-correlated with the stock market, so they can be used to prevent negative dollar cost averaging. That is, if the market is down, you don’t have to sell low in order provide income during retirement. Selling low locks in the losses and is the only cardinal sin in investing. Instead, harvest a buffer asset when the market is down.
What is a Buffer Asset?
Like many terms in retirement planning, “buffer asset” doesn’t have a clear definition. Pfau derived the term from cash value life insurance’s “volatility buffer.” Specifically, he refers to buffer assets as those assets outside of your investment portfolio where returns are not correlated with the stock market. As examples, he cites cash value life insurance and reverse home mortgages.
Other assets have the same intent, however: to immunize your portfolio against sequence risk and prevent reverse dollar cost averaging.
Let’s see if we can describe a classification system for sequence risk mitigations.
Classification of Ways to Mitigation Sequence Risk
A classification system for system risk mitigation is lacking, but I propose the following classification scheme:
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
During downturns in the market, think about strategies and investments that may be less affected by the chaos.
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.
Let’s look at the effect some of these mitigation strategies have on a fictional portfolio during an especially bad sequence–the years 2000-2010.
Consider a fictional couple who just retired at 64. They have $4.5M in assets which includes a $1M house, $500,000 in cash value life insurance, and $500,000 of LLC shares paying 5% a year.
Figure 1 shows the asset allocation of the $2.5M portfolio. They have a $1M taxable account with a large cash reserve, and US and International stocks and bonds. In their $1M rollover IRA, they are 60/40 US stocks/bonds. Their $500,000 Roth IRA is more aggressively invested. (Spreadsheet from PoF)
Social security will provide $3000 a month at age 65. They plan on spending $150,000 a year, a 6% withdrawal rate from their investments or a 3.3% withdrawal rate from combined assets.
Figure 2 (Assumed sequence for this scenario)
Figure 2 shows the sequences from 2000-2010 against which we will stress various scenarios. Note from year 11 until the end of plan, return on stocks is 6%, bonds 3% and cash 2%. These may be low on average, but are nonetheless interesting to look at as an added stress.
Results of the Plan
Monte Carlo simulation of this plan demonstrates an 82% success rate using standard returns on financial planning software. Stress testing reveals concern for a market crash, inflation, and longevity. Net worth at year 90 (end of plan) is $5.8M with their portfolio worth about $3.8M.
When we stress this plan with return assumptions from figure 3, however, there is a zero percent chance of success and their portfolio expires at age 84.
Now, let’s examine some different options for mitigating the portfolio against sequence risk.
Delay Social Security
What if they delay claiming social security? The dark green demonstrates portfolio value over time if they delay to 70. The lighter green shows portfolio value if they claim immediately. Over time, we see the investment accounts expire at age 84 with either strategy.
The cross over point where income from social security is higher as a result of a delayed claiming strategy is age 79. It is interesting to note they actually do worse with a delayed claiming strategy as they have a higher distribution rate from the brokerage account prior to claiming, and this occurs during some very negative years of market returns.
Therefore, claiming social security early to mitigation a poor sequence does not effectively immunize a portfolio. During years of negative stock market returns, decreasing the withdrawal rate slightly (by claiming early) does not make up for the loss of income in the long run.
A More Conservative Allocation
What if they were more conservatively allocated? Figure 4 shows the effect of a 20/80 portfolio, where they have 80% of their assets allocated to fixed income. Although they suffer from less volatility (especially during the down years), they only have an extra $500,000 after the poor sequence. However, the initial draw down in the portfolio value is eventually eaten away by inflation, and the portfolio expires at year 87.
A rising equity glidepath or a bond tent would improve this scenario. These allow programmatic increases in equity exposure without “market timing.” Unfortunately, however, I’m not able to demonstrate these changes in portfolio allocation with current planning software. This is a good reminder that a financial plan is not set in stone and requires periodical re-evaluation.
Bond and CD ladders are popular for SORR planning. For a large upfront investment, you can guarantee 5 or more years of income.
In this scenario, $500,000 is used to purchase an 8-year treasury bond ladder paying out $75,000 a year. A Bond/CD Ladder Toolkit helped model the purchase price.
As seen above, this bond ladder fails. Note that at year 9 there was a large drop in market prices, so perhaps a 10 year bond ladder may have performed better. CD ladders or use of MYGAs are not modeled, but also suffer from current low interest rates.
Given low current interest rates, a treasury bond or CD ladders are not all that exciting. Historically, when interest rates were closer to 6%, a similar bond ladder costs about 20-30% less.
What about Selling a Business?
They do have assets outside of their portfolio. Figure 6 shows income sources for retirement. As seen above, when they are 65 years old, they sell the LLC and receive $500,000 in income (though they lose the 5% returns for the rest of the plan). In this scenario, they still run out of money at age 84. A poorly timed infusion of cash is not beneficial during these harsh sequence. The income peak at age 90 is the life insurance policy paying out upon death.
What About Annuities?
In this scenario, the fictional couple really didn’t need income, so models of single premium immediate annuities (SPIAs) are not shown here–they didn’t help mitigate against sequence risk in this scenario anyway. Let’s look at differed income annuities (DIAs) and see if it can mitigate sequence risk.
Income sources are shown above with a DIA. Assume $500,000 from the brokerage account purchases DIA payments of 14.2% after a 10-year deferral period. Note that we have social security and income from the LLC. At 10 years the annuity starts to pay, as well, but their investment accounts run dry at age 83. The large withdrawal from the brokerage account raises the withdrawal rate from the portfolio higher than can be tolerated during SORR, leading to this poor result.
Get a Job
What about working in retirement to increase income? Given their high spending levels, they would have to earn $60,000 a year for 10 years in order for Monte Carlo analysis to be above 50%. They are already in high tax brackets from other income, and it is difficult to out-earn their high spending rate.
What Actually Works?
Let’s now move on to demonstrate effective ways to avoid SORR in this scenario.
Variable spending strategies are important for retirement income planning. Logically and emotionally, this is what most retirees will do during down markets.
Note that the portfolio is not much larger even after the second major decrease in the stock market, but the tail end stays much higher showing that likely they could have increased spending again after the sequence of risk evaporated (usually about 10 years).
Cash Value Life Insurance
You can “borrow” the cash value of a permanent life insurance product tax free. In this example, $40,000 a year is borrowed from the cash value of the policy for 10 years. Even though this is a fraction of their spending, the results are impressive, and this plan does not fail. Cash value life insurance is not a popular topic among DYI investors, but clearly it is a consideration for those worried about sequence risk. You can pay back the money you borrow from your life insurance or it can be deducted from the death benefit when the time comes.
The problem with borrowing from your cash value life insurance policy is, of course, it must be set up decades before it is needed. In this example, the life insurance is counted as an asset, but of course this is an asset outside of the portfolio and not correlated with stock returns, which is why Wade Pfau finds them so useful.
Reverse mortgages have become slightly more popular in the last few years, mostly thanks to a book by Wade Pfau. He suggests a Home Equity Conversion Mortgage (HECM) to be used early in the planning process, rather than as a last resort (as home mortgages are considered in popular culture). These are FHA loans with mortgage insurance written into the deal. HECMs are non-recourse loans, which means as long as the property is kept up and property insurance and taxes are paid, the homeowner keeps title and cannot be evicted. Loan-to-value amount is based upon the owner’s age (you must be at least 62) and current interest rates. The lending limit is based upon a maximum value of $726,525 and is usually 40-60%.
HECMs have a line of credit option which is of most interest. You can open the account and only use it if needed. Also of note, this line of credit grows larger with time.
In order to combat a negative sequence, draw on your line of credit in years when equities are down in order to avoid reverse dollar cost averaging. Money from the line of credit is tax free, which may be especially important if you are getting income from your fully taxable IRA, or if additional ordinary income would increase taxation of social security, or cause increased Medicare surcharges.
Above, in figure 10, you can see that a reverse mortgage does in fact adequately mitigate sequence risk.
So, Which Mitigation Would You Choose?
In summary, only three strategies perform well against a repeat of the market foibles from 20 years ago.
Spending less money, or even a variable spending plan, is an important consideration.
Other effective assets to consider are reverse mortgages and cash value life insurance. Obviously, cash value life insurance must be set up decades in advance, but is a consideration for high income individuals who already have large tax-deferred retirement accounts. While reverse mortgages can be set up anytime, the amount you are able to borrow from actually increases with time if you set up your mortgage early (though of course after 62). The key to these assets: they are not correlated with stock market returns, and equally important, the “income” is tax free.
Final Thoughts on Mitigating Sequence Risk
Thus, it does take planning to make sure you don’t crash and burn due to sequence risk in early retirement. That actually is the point of retirement planning. No single mitigation strategy is perfect for everyone. Likely a combination of investments, products, and strategies will be needed in order to spend freely during your early retirement all the while planning to live a long and comfortable life.