Signs that the American retiree may soon be living the nightmare of sequence of returns have now emerged, and it’s incumbent on advisors to build an active line of defense into client portfolios with a sense of urgency, said Michael Kitces, an industry consultant and expert in retirement income planning.
Sequence of returns risk—the phenomenon that occurs when a healthy portfolio is subjected to low returns and high inflation early in the drawdown period to the point that it never recovers and retirees are left years short on assets—tends to correlate to market environments where PE ratios for stocks are high while the 15-year real return of the 60/40 portfolio is low, research shows.
And that’s exactly where U.S. investors find themselves today, he said during a presentation on strategies for combating sequence risk at Schwab’s IMPACT 2023 conference held last week in Philadelphia.
“This is ludicrously predictable. The lines move almost perfectly in tandem with each other, in opposite directions,” he said.
But one thing advisors often get wrong about sequence risk, he continued, is that the risk doesn’t lie in just a couple of bad years of returns right when a client retires.
“Sequence of returns risk, it turns out, is mostly about what happens in the first decade after retirement, magnified,” he explained, adding that while clients should fear a market crash early in retirement they also should fear volatility and a slow recovery or an extended period of low returns.
“If the first decade is really bad, if you’re not doing something to defend against that bad decade, whatever assets you have slowly run out and you eventually have a problem,” he said.
To reduce the risk that clients will take such a hard hit on the front end of their retirement that they will run out of money years before they expect to die, Kitces suggested advisors look at seven strategies that fall into three primary categories—safe withdrawal rates, dynamic asset allocation and dynamic spending.
“Different advisors will do it in different ways, and I’m not here to particularly say you have to do one of these over the others,” he said. “Some of us have a preference just based on our styles. Some of us like to mix and match. Some like buckets but also like guardrail spending. Others just want to do a safe withdrawal rate approach, with some dynamic asset allocation. Whatever. These are all strategies that we get to pull out of the quiver to figure out how to help clients defend against sequence of returns risk.”
A Safe Withdrawal Rate
While retirement research has pinned an annual 4% withdrawal rate, adjusted for inflation, as conservative enough that a retiree will not outlive their money, some financial institutions have suggested an even lower rate is required in recent years.
“I find the withdrawal rate research is actually not well understood. I see a lot of discussion over recent years that the 4% rule is broken because we’ve been in a lower returns environment then when the original research was conducted. But that’s not actually how it works,” he said.
Instead, the safe withdrawal rate is based on an analysis of the worst 30-year-returns sequences in history. The average withdrawal rate that would have gotten most people through all of those was 6.5%, the research showed.
But the truly safe withdrawal rate—“a rate for when we get a market sequence that is as bad as anything we’ve ever seen in history, and you will survive by definition”—is 4%, he said.
“It’s actually a remarkably robust number,” Kitces said. “The irony is that not only is it robust, it overwhelmingly leads to massive amounts of excess wealth in most scenarios.”
Another way to express the 4% rule, he said, is that it’s a 96% Monte Carlo scenario that the client will have 100% of their principal left over. Not just a lot of money left over, but all of their starting principal at the end of 30 years.
“And half the time, the immediate result is you’ll more than double your retirement wealth,” he said. “In one scenario, you’ll be about to get to zero. There’s a 1% chance of that.”
In addition, the original 4% number was built around just three asset classes making up the investment portfolio, large-cap U.S., small-cap U.S. and long-term bonds.
“There was no international, no commodities, no alts, and nothing else in the bond structure,” Kitces said, adding that all of those options give today’s advisors an opportunity to take advantage of better-performing areas of the market that weren’t included in the original scenario.
Dynamic Asset Allocation
While simply adhering to the safe withdrawal rate will be enough of a strategy for many clients, there are additional ways to structure a portfolio to address sequence risk or to add another layer of management, Kitces said. These include dynamic asset allocation strategies such as bucket strategies, an annuitization floor, a rising equity glidepath, and valuation-based asset allocation.
“Retirement research shows about third of us use some version of a bucket strategy,” he said. “The simplest version of this is you have three different buckets—your near-term spending, your intermediate spending, and long-term spending,”
The near-term spending bucket contains assets the client needs in the next three years, held in cash or cash equivalents. The intermediate spending bucket covers years four through 10 and is invested in a bond ladder. The rest of the assets are invested in equities for growth.
For many clients, this will translate into a portfolio that’s roughly 15% cash, 35% bonds and 50% equities, Kitces said.
“It’s not actually that different than what most of us would otherwise do for a low-risk tolerant client,” he said. “But clients think about it really differently. It sounds totally different when I talk about the three-year bucket and a seven-year bucket and then the long-term bucket, instead of saying we’re at a 50%/50% portfolio rebalanced every year. A and yet it’s basically the same thing.”
Another strategy is to segment the portfolio into buckets based on spending. Here, the client would have one bucket representing essential expenses and another for discretionary expenses.
“The essentials bucket I’m going to cover with guaranteed income. These are true essentials: food, clothing, shelter kinds of things, not the Netflix account I can’t live without,” he said. “The whole point here is you cannot outlive your essentials expenses. They’re essential.”
Many clients in practice cover the bulk of their essentials bucket with Social Security, he said, but if they don’t have enough they can buy an immediate annuity to fill in the shortfall. They don’t need to annuitize the whole portfolio, he said, just enough to cover the essential expenses.
All other spending is considered disretionary, and that is covered by portfolio withdrawals.
“If bad things happen in the portfolio, the only thing that’s at risk are the discretionary expenses … wants, not needs,” he said. “So in essense, we manage the sequence of returns risk by compartmentalizing only the expenses that we would be able to lose if we have to. We’re hoping we don’t, but we can compartmentalize the risk down to the spending that would not be castrophic.”
The next two strategies—a rising equity glidepath and valuation-based asset allocation—are byproducts of the annuitization floor. While they don’t change the income to the client, they do change the asset configuration, which can also add protection against sequence risk, Kitces said.
When a client covers essential expenses with Social Security plus an annuity topper as needed, the rest of the portfolio can be invested for growth, without much concern that a bad market will ruin the client. The value of the discretionary portion will rise over time.
“From an income perspective, they’re just kind of different channels. But from an asset perspective, they look very different. My guaranteed-income streams are essentially a proxy for fixed income. Social Securtity functions like a government bond,” he said. “I could carry my Social Security payouts as an actual asset on my balance sheet. Most of us don’t calculate the capitalized value, but we could.”
The same with the client who takes an immediate annuity to finish covering essential expenses, he continued. They’re taking an asset on the balance sheet and turning it into an income stream.
“If you did that, we would find that most clients actually have heavier obligations to fixed Income than they get credit for. If you actually capitalize the value of social security on the balance sheet, depending on client income and whether it’s one or two to Social Security earners, Social Security for most households is $300,000 to $700,000 of fixed-income assets on the balance sheet,” he said.
At least it is when the client retires. By the time the client is in their 80s, it’s worth much less because the value of the Social Security going forward has been depleted, he said. Same thing with the value of the annuity.
“The significance of this is, if my portfolio is growing through retirement and the value of my Social Security and the annuity is coming down through retirement, if I actually look at my balance sheet on a holistic basis, what’s happening to my equity allocation? It’s rising,” he said.
The client who starts off with half their wealth in Social Security and half their wealth in a portfolio ends up with a 90%/10% equity-fixed income split by the end of their retirement, he said.
“Now, if I went to those clients and said, ‘I’ve got a great retirement income stratey, you’re just going to bump up your equity allocation every year as you get older,’ most people would look at me like I’m crazy,” he said. “Except that’s actually what we all do in practice.”
Since advisors keep the client’s equity allocation the same every year, as the value of their Social Security is diminishing, the client’s wealth becomes more equity-centric every year they live through retirement, he said.
“This is actually a good thing for retirement income. From a sequence of returns risk perspective, markets may go up and down and up and down, but it actually matters a lot if they go up and then down versus if they go down and then up,” he said. “Where you hit it in the timing is the sequence of returns risk.”
If the market goes up first, then it doesn’t matter how aggressive a portfolio is, it’s just compounding wealth on wealth, he illustrated. But if the market goes down first and the equity allocation is getting more aggressive through retirement, the client ends up owning more stocks just when they need them, which defends against sequence risk.
With valuation-based asset allocation, an advisor can take advantage of occasional tactical shifts in asset allocation to maximize returns. Kitces’ own model starts with an equity allocation at 45% with guardrails of one standard deviation above or below, triggering reallocation.
“If you own a 45% equity model, and it goes up to 60% in good times, down to 30% in bad times, and 95% of the time it just stays in the middle,” he said. It’s just those swings that 5% of the time that would require rebalancing, and those occur on average only twice a decade.
“Even if you do something as simple as this, it lifts sustainable spending rates by about 20%, so a 4% spending rate goes to about 4.8%,” he said. “Just by maintaining gentle shifts in allocation.”
On top of the safe withdrawal rate, and with or without dynamic asset allocation, clients can also address sequence risk by tinkering with their spending through a “ratcheting” strategy or by using floor/ceiling guiderails.
For clients who like the feeling of spending more when times are good and don’t mind reining in their spending in when times are tough, adjusting spend levels can result in clients enjoying their retirement more than if they’re forced into a level spend over 30 years, Kitces said.
“The safe withdrawal rate framework essentially says we’re just going to spend so little that we won’t run out of assets. But in practice, some clients might say, ‘Hey, thank you for the retirement guidance, but my goal was not actually to septuple my wealth for my kids, it’s actually to enjoy my wealth before I get to 87 years old,’” he said.
To give clients that extra fun without sacrificing safety, Kitces recommended two approaches.
The first is a ratcheting approach, where, like a ratchet wrench that moves only in one direction, the withdrawal rate is increased under certain conditions, but never decreased.
“We’re going to start somebody with a safe withdrawal rate of 4%, maybe 5%. But if we start getting a good sequence and we get ahead, and if we’re far enough ahead, we’ll give them a raise,” he said.
In the simple version of the ratcheting strategy, if a portfolio value is ever up more than 50% on its starting balance, the client gets a 10% raise on spending in addition to the inflation adjustment. The portfolio value is looked at every three years to assess the client’s position, not annually, to avoid ratcheting up too quickly.
“We keep spending ratcheted down tight when times are bad, but when good times come they actually become so good you can start dialing up your spending,” he said.
Clients who are willing to ratchet both up and down according to market conditions can start with a safe withdrawal rate but then add guardrails. For example, if the client’s starting safe withdrawal rate is 5%, they can actually withdraw up to 6% when the markets are doing well and drop down to 4% when the sequence of returns isn’t favorable.
“I still remember one of my earliest clients who were pretty high wealth and very big spenders. They loved doing massive trips around the world where they’d blow tens of thousands of dollars going to multiple countries. And would do this once or twice a year, every year,” Kitces illustrated.
Their spending rate at the time was actually around 6.5% or 7%, just as the markets were coming off the tech crash of the early 2000s. And they rejected every effort Kitces made to reduce their spending, he said.
“They said, ‘This is the lifestyle we worked for. If the markets go badly, call us and we’ll come home and stop. But if the markets don’t go badly, this is the lifestyle we worked for.’ So you can build bumpers for these clients,” he said. “I think of the bumper lanes at bowling alleys where we take our kids. My daughter rolls the ball down the bumper lane, and if she rolls it fairly straight, it just goes straight down and hits the pins. If she’s a little off and it runs askew, it hits the bumper and then bounces off and hits the pins. Every time she rolls the ball, she knocks pins down and she’s thrilled. Because we have bumpers in place, either she gets a clean roll or she bounces off a bumper and gets a safe roll. We can do this with clients as well.”
No matter what strategies advisors use, now is the time to set them in place and make sure the client understands them, Kitces said.
“It doesn’t matter if returns average out over 30 years if you don’t any money left when the good returns finally show up,” he said. “You can have a raging bull market in the last five years of the portfolio, but if you ran out of money with eight years to go, it doesn’t matter. Doubling zero is still zero.”