# Coping with Sequence Risk: How Variable Withdrawal and Annuitization Improve Retirement Outcomes

Both the level and the sequence of investment returns will have a big impact on retirement outcomes. Poor returns during the early years of retirement are bad news. However, the particular withdrawal strategy used affects sequence risk, and an approach where withdrawals are variable and respond to portfolio performance can improve retirement outcomes. I’ll examine the evidence and then use my own modeling to show how a strategy that combines variable withdrawals with partial annuitization using a single-premium immediate annuity (SPIA) maximizes the cash available for consumption.

**Key aspects**

To gain a better understanding of sequence risk, I strongly recommend a series of five posts produced in 2013 by Dirk Cotton on his “Retirement Cafe” blog. The third post, “Sequence of Returns Risk and Payouts” delves into the impact of switching from fixed withdrawals set at the beginning of retirement to a variable approach where annual withdrawals are based on current portfolio values. The classic example of a fixed strategy is the 4% rule, where withdrawals are set at 4% of the initial portfolio and adjusted each year for inflation (i.e., fixed in real terms). The particular variable approach that Cotton used for comparison is known as the endowment method, where each year’s withdrawal is X% of the current portfolio.

Cotton developed an example where he took six recent annual stock market returns, rearranged them into 720 possible sequences, and then tested a fixed withdrawal strategy ($25,000 per year from an initial $1 million portfolio) on each of the 720 sequences. He showed that, even though the same six returns were used in all 720, the terminal values at the end of six years differed considerably. This is the essence of sequence risk – same returns, different sequences but different outcomes.

He then used the same 720 possible sequences, but changed to a withdrawal approach where annual withdrawals were 2.5% of the existing portfolio. He demonstrated the surprising result that, even though the portfolio values followed a variety of different paths over the six years, all 720 ended up at exactly the same amount. A quick reaction to this result might be that variable withdrawals eliminated sequence risk – but, as Cotton has illustrated, there is more to the story.

Switching to variable withdrawals does, indeed, dramatically reduce the variability of terminal or bequest values. However, it does this by adjusting the withdrawals. A “bad” sequence – poor returns in the early retirement years – will generate lower average withdrawals than a “good” sequence. So changing from fixed to variable withdrawals doesn’t eliminate sequence risk; it transforms a bequest risk into a payout risk.

But then we are left with the question, “Is it better to take bequest risk or payout risk?” For clients who are wealthy enough it may simply be a matter of priorities; do they care more about consumption or the size of their future bequest? However, for more constrained clients, analysis of potential outcomes is required.