Pensions  

How to manage sequence of returns risk

  • Describe some of the challenges around sequence of returns risk
  • Describe a straightforward way to mitigate that
  • Explain the advantages of dynamic spending
CPD
Approx.30min

The 1973 retiree would have run out of money 23 years into retirement.

By contrast, the 1974 retiree would have maintained a balance of $300,000 for most of the 35 years of retirement and would end that period with around a quarter of the initial amount to leave as a bequest. 

The difference in these outcomes offers a striking illustration of SORR. A single year’s difference in the start of the retirement period led to a drastic disparity in the performance of the portfolios. 

This is simply because the 1973 retiree bore the full brunt of the bear market as he or she began to make withdrawals – and that bear market continued until hitting its bottom in October 1974.

The 1974 investor experienced only nine or ten months of the bear market, which meant the initial withdrawals into a falling market had a less severe impact on the size of the portfolio over the longer term. 

A potential solution: dynamic spending

As our examples show, SORR can have a devastating effect on the performance of a retirement portfolio.

Obviously, there is nothing that individual investors can do to change the behaviour of the world’s financial markets.

Nor can they combat the power of compound returns. But investors can act to mitigate the effects of bear-market conditions by adopting a different, more flexible spending strategy.

The key to this is simply to reduce portfolio withdrawals when markets are falling. We call this ‘dynamic spending’.

Under a dynamic-spending approach, you adjust your withdrawals according to market performance. So, after a poor year for markets, you withdraw less than you had originally planned – although the income need only be reduced by a surprisingly modest amount. 

This may cause you some short-term privation through reduced income, but it does help to mitigate the compounding effect of taking significant withdrawals from a portfolio that is already being diminished by negative returns.

Conversely, when markets recover, the dynamic-spending approach allows withdrawals to be ratcheted higher. 

Floors and ceilings

The dynamic-spending process acknowledges the way in which compounding works against an investor who is making withdrawals at a time when markets are falling.

By withdrawing less during those periods, you shield the portfolio from the full effect of the damage done by the combination of withdrawals, market falls and compounding.

The easiest way to benefit from dynamic spending is to use set formulas to determine how much income an investor should receive each year.

We did this in our modelling by setting an initial spending target of $25,000 (5 per cent of the portfolio’s value, as in the fixed-spending approach in our example above).

For the next year, we multiplied the portfolio’s value by 5 per cent and compared that figure with the previous year’s spending. If the new figure was higher, we increased it up to a predetermined ceiling (for example 5 per cent higher than the previous year).

CPD
Approx.30min

Questions appear on the last page of this article.