Real-Life Strategies to Mitigate Sequence-of-Return Risk

The first few years of retirement are the most vulnerable to risk from adverse market movements. Clients nearing or in retirement ask me how to mitigate that risk. There are many methods I’ve reviewed; most have problems and a few even increase that risk. I’m going to review the research on safe spending rates and then critique common methods of risk mitigation.

I’ll offer the practical methods to reduce sequence-of-return risk that I suggest to my clients.

Safe spending rates

I’ve done extensive Monte Carlo modeling. Though there has been quite a lot of criticism of Monte Carlo modeling, much of it is misplaced. Many Monte Carlo simulation outputs are garbage, but the fault is in the assumptions, not the modeling. As they say, “garbage in, garbage out.” Assuming past returns will continue is dangerous. So is ignoring costs. One fair criticism is in the use of a normalized distribution when we live in a world of fat tails. For example, at the start of 2022, the yield on the Bloomberg U.S. aggregate bond index (AGG) was approximately 1.6%, which represented the expected return for that asset. But since then, through June 3, the return for the AGG has been -9.15%, which is a three standard deviation event. That should happen once every three centuries. If rates continue to rise, we will soon hit four standard deviations, which would truly be a black swan event. Jason Zweig recently wrote in The Wall Street Journal that this has been the worst start of the bond market since 1842.

My own simulations come up with safe spending rates (increasing with inflation) far below the famous 4% rule. The best work I’ve seen came last year from Morningstar with its paper, The State of Retirement Income: Safe Withdrawal Rates. The study by Christine Benz, Jeffrey Ptak, and John Rekenthaler replaced the 4% rule with the 3.3% rule, meaning a portfolio of 50% equities has a 90% chance of lasting 30 years or longer.1 But that is not for everyone; the asset allocation greatly impacts the outcome. Based on a 90% success rate, they came up with the following table, showing the safe spending rate depending on the clients’ life expectancies and asset allocation:

The future is very hard to predict, and 90% success may be exaggerated when considering long periods of time. That’s why it’s important to have ways to mitigate risk rather than blindly spending at these percentages with increases each year based on inflation.

Traditional risk-mitigation strategies

There are several traditional ways of mitigating sequence-of-return risk. Many have emotional appeal but are flawed. Here are a few: