Biggest risk to retirement cashflow and how to deal with it

(Originally posted in 2020)

We do our best to avoid using an abundance of personal finance jargon and acronyms. Improving how easy our advice is to understand without using these comfort words has been a rewarding, yet challenging task. There is however one term we commonly hear being used, and that is “burn rate.” This seems to be one of the few examples of financial jargon that everyone has adopted when discussing their financial plans. We assume that this is because people intuitively understand how much of an effect their own spending habits (“burn rate”) have on retirement success.

What is Sequence of Return Risk?

At Camber, we are avid readers of academic retirement research papers and recently watched an interview featuring one of our favorite researchers, Michael Kitces. During that interview, Michael discussed a key risk to retirement success called “sequence of return risk.” Understanding this risk is important because it can have a dramatic impact on your retirement. Sequence of return risk simply outlines that getting bad market returns early in retirement is far worse than getting those same poor returns later on. Unfortunately, if not addressed, your luck in retirement can make a big difference to your long-term success.

Sequence of return risk occurs when the value of your investments decrease early in retirement and you need to make withdrawals. Each withdrawal, in this scenario, means that you have to sell more units to receive the same amount of income. If this occurs for a few years early in retirement, you would have less units left to participate in a market rally. Meaning that there are scenarios where you could run out of money. The good news is that there are strategies related to how you build your portfolio and withdraw funds that can be used to combat the effects of bad luck early in retirement.

Throughout the interview, Michael discusses the three withdrawal strategies that you can employ to combat this risk. All of which require you to know your “burn rate.” There are a lot of subtleties and detail that go into this calculation and having access to financial planning software produces the most accurate result. For simplicity, the calculation can be understood as a percentage of total liquid assets.

The Conservative Method

The first method that Michael outlined is simple, if you keep your “burn rate” below 4% per year ($39,000 withdrawal from $1,000,000), you are considered to be spending conservatively and the effects of sequence of return risk, are negligible. This 4% threshold has been used for many years when making long-term retirement plans and is still the target today. Taking these minor amounts from your portfolio each year paired with the incremental stress caused by a few poor years, ultimately has no real effect on your retirement success.

The 5% Bumper Method

The second method requires a little more attention as it is designed to keep your withdrawals within a 4% – 6% range, starting with 5% at retirement ($50,000 withdrawal from $1,000,000). Michael uses the analogy of a bowling lane to explain this strategy and equates the acceptable range to the two bumpers that prevent your ball from going into the gutters. The middle of the lane is 5%, and you only take action if you hit either the 4% or 6% bumper.

As we monitor the plan each year, two adjustments are possible. First, if the portfolio is increasing in value then the $50,000 withdrawal represents a smaller percentage of the total portfolio. For example, the withdrawal is now worth 4.8% of the total ($50,000 withdrawal from $1,041,700). If this trend continues and the withdrawal rate falls all the way to 4% ($50,000 withdrawal from $1,250,000) then a 10% ($5,000) raise would be taken. However, if the investment portfolio is coming down in value, the $50,000 becomes a higher percentage of the portfolio. When the withdrawal rate hits 6% ($50,000 withdrawal from $833,333) then a 10% ($5,000) cut is taken. These two adjustments help keep your retirement spending in line just like the bumpers help keep your ball out of the gutter.

The Top-Up or Trim Down Method

The third and final method is used in situations where your “burn rate” is more than 6% ($65,000 withdrawal from $1,000,000). This strategy requires that you cut expenses and/or add income so that the 5% bumper method can be used. Research indicates that retirees benefit greatly from being active, social, and challenged in retirement. Adding income through part-time work, consulting, or starting a small business can bring your withdrawal rate down to the 5% target without sacrificing your lifestyle. There are also a number of added physical and psychological benefits associated with these activities. If you are able to generate an additional $15,000 of income for the first decade of retirement, your $65,000 withdrawal requirement comes down to $50,000 (5%). Some may decide that they would prefer to cut expenses instead of work.

Academic research indicates that some methods of cutting expenses work better than others. Large-temporary cuts are the least effective. For example, cutting your expenses by 30% for three years, while the markets are down, then reverting back to your prior withdrawal rate is rarely done successfully. The most effective method is to make small-permanent changes. Michael uses the example of deciding not to index your withdrawals to inflation (2%); effectively taking less and less over time.

The Latte Factor

Another way of doing the same thing would be to review your spending and simply choose some small things you can permanently live without; this is known as “the latte factor.” In addition to these small-permanent changes, removing large-infrequent purchases will help to further reduce your withdrawal rate. These cuts can take the form of looking at cars that cost 25% less and driving them for two years longer than normal. Combining additional income with small-permanent changes is a very effective way to bring your withdrawal rate within the bumpers and negate the effects of a bad sequence of return early in retirement.

If you do not trust yourself to make these kinds of changes or work within these limits for a number of years, you have two choices. Either convert much of your portfolio to an annuity, imposing a sustainable withdrawal plan on yourself; or, seek the support of a financial planner who will hold you accountable to those good behaviours.

The Bond-Tent

There is one more alternative strategy that you can use, which involves portfolio design. You can strategically modify your portfolio to bring down the risk of realizing poor returns early in retirement. Sacrificing some potential for growth early in retirement can save you big losses if luck is not on your side. Michael calls this strategy a “bond-tent.” Executing this strategy requires that you simply replace some of the equity exposure in the first account being drawn down in retirement, with bonds. If the stock market goes on a tear, you still get the returns generated by the bonds but miss out on the returns that having the higher equity exposure would have given you. In exchange, if luck works against the equity portion early in retirement, the bonds can be sold so that the equity units have a chance to recover. In this scenario, equity exposure is actually increasing in early retirement as the bonds are sold, which is exactly what would be recommended in anticipation of a market recovery. A bond-tent is generally used when avoiding a sequence of negative returns is more valuable than the slice of growth you have to sacrifice.

We talk to our clients about asset allocation and spending almost more than any other topic. Hopefully, this article helped you gain a better understanding of ways to combat sequence of return risk