Sequence of returns risk

[rudged]

I was just listening to an online talk by Wade Pfau (an expert on retirement planning) who made a fascinating claim about risk associated with sequence of returns made famous by the 4% rule [https://www.youtube.com/watch?v=0wrRSYsTbus&list=LL&index=2]. 

He claims (time stamp 59') that if, instead of regularly making 4% withdrawals adjusted for inflation regardless of how the market fares, you choose instead as your rule that you would limit your withdrawal each year to 4% of the total value of your portfolio, you could avoid the risk entirely. (The problem, as he sees it, is that most people are unable to/unwilling to dramatically alter their spending plans on a year to year basis depending upon the volatility of the market.)

This certainly makes sense - withdrawing 4% each year of what remains can be done indefinitely regardless of how the market fairs (unless all of your assets went to 0). But I'm wondering if I misinterpreted him.

[seattlecyclone]

I think you got it. Really, you could take out 50% every year and never run out of money, but doing this you're going to spend much less every year and will eventually find your budget to be too constraining.

[rab-bit]

Ability to cut back is also a function of how much slack you have in your budget relative to the 4% withdrawal rule (i.e. lean vs. fat FIRE).

[nereo]

Yup - it’s just math. If you take out only a percentage is your remaining portfolio you cannot run out of money, but you will not know in advance how much money that will be (and this uncertainty grows the further or you are). FWIW historically this strategy has worked rather well in most markets (I.e a retiree had an overall increase in withdrawals over their retirement.

If this interests you, read up on “variable withdrawal rates (VWR)”. Another common strategy is to start very lean (say 3%) and with designed flexibility, only to increase substantially later

[terran]

You withdraw 10% of your portfolio every year and never run out of money because 90% of an amount of money is greater than $0. Most people's spending isn't as flexible as a straight percentage withdrawal rate would require.

Something to note about Wade Pfau's research is he usually assumes a high (1% I think?) advisor fee, and he gets a lot of funding from the insurance industry, so I've heard, with whatever incentive that might provide to push annuities. He's undoubtedly a smart guy, and I'm not saying his research is influenced, just that it's something to consider.

[Telecaster]

Something to note about Wade Pfau's research is he usually assumes a high (1% I think?) advisor fee, and he gets a lot of funding from the insurance industry, so I've heard, with whatever incentive that might provide to push annuities. He's undoubtedly a smart guy, and I'm not saying his research is influenced, just that it's something to consider.

He's a smart guy, just don't take his advice  :)

[rudged]

Something to note about Wade Pfau's research is he usually assumes a high (1% I think?) advisor fee, and he gets a lot of funding from the insurance industry, so I've heard, with whatever incentive that might provide to push annuities. He's undoubtedly a smart guy, and I'm not saying his research is influenced, just that it's something to consider.

I'm pretty sure you are mistaken about this. He is a professor and co-director of the New York Life Center for Retirement Income. In several of his talks he stresses he does NOT work for an insurance company and that his services are fee based.

[Freedomin5]

Something to note about Wade Pfau's research is he usually assumes a high (1% I think?) advisor fee, and he gets a lot of funding from the insurance industry, so I've heard, with whatever incentive that might provide to push annuities. He's undoubtedly a smart guy, and I'm not saying his research is influenced, just that it's something to consider.

I'm pretty sure you are mistaken about this. He is a professor and co-director of the New York Life Center for Retirement Income. In several of his talks he stresses he does NOT work for an insurance company and that his services are fee based.

From the Center’s website:

The American College New York Life Center for Retirement Income was established through a generous grant from the New York Life Insurance Company in 2007.

Not sure if that means it currently continues to receive funding from New York Life Insurance Company...

[rudged]

Not sure if that means it currently continues to receive funding from New York Life Insurance Company...

Good point. I do think it is important to distinguish between someone who advocates consideration of insurance products (e.g. annuities, life insurance) out of a sincere conviction that they are more efficient when it comes to certain retirement goals and someone who does so because he or she stands to get a commission.

I note wealth management advisors potentially have a similar bias, namely they might down play the use of insurance products because if their clients were to do so, the size of the portfolio being managed would decrease, reducing the advisor's commission.

[PhilB]

Ability to cut back is also a function of how much slack you have in your budget relative to the 4% withdrawal rule (i.e. lean vs. fat FIRE).

The corollary to this is the awful truth that the more fat you have in your FIRE, the higher the withdrawal percentage you can afford to use.  Yet another case of 'to those that have shall be given more.'

[mistymoney]

I'm not seeing the two approaches as so very different - leastways, not the way I would implement them. If you do the 4% first year to set budget and then just tack on a 3% increase annually - are you really going withdraw and spend the "scheduled" amount if the market tanked 20% or more one year? I wouldn't! Seems reasonable to rein in some splurging or delay big ticket items for a bit.

If you do 4% on whatever the yearly balance is, and the market doubles one year - will you splurge on everything under the sun to spend twice what you did last year? If the market drops 35% the 2nd or 3rd year and you can't pay all your bills - are you really going to let them go to collections rather than dipping in for a little bit more than 4%? I didn't think so!

Maybe a hybrid - 4% of year 1 balance, increased by 3% for inflation every year but never to exceed 4% of current total balance unless needed for base expenses?

[bacchi]

I'm not seeing the two approaches as so very different - leastways, not the way I would implement them. If you do the 4% first year to set budget and then just tack on a 3% increase annually - are you really going withdraw and spend the "scheduled" amount if the market tanked 20% or more one year? I wouldn't! Seems reasonable to rein in some splurging or delay big ticket items for a bit.

If you do 4% on whatever the yearly balance is, and the market doubles one year - will you splurge on everything under the sun to spend twice what you did last year? If the market drops 35% the 2nd or 3rd year and you can't pay all your bills - are you really going to let them go to collections rather than dipping in for a little bit more than 4%? I didn't think so!

Maybe a hybrid - 4% of year 1 balance, increased by 3% for inflation every year but never to exceed 4% of current total balance unless needed for base expenses?

Yeah, few people are economic automatons. If the market collapses, and foreclosures are rampant, most people naturally delay major purchases. (However, that may just be the best time to get work done on the house or take a nice vacation.)

I use the bogleheads VPW method with a floor. It requires predicting your death :) but I'm generous. We're also running under our yearly withdrawals.

[PhilB]

I like the idea of coupling the withdrawal of a fixed percentage of portfolio with a cash buffer to smooth out part of the variability - eg a one year buffer would allow you to turn a 50% market crash into a 25% spending reduction for 4 years.  If that actually happened though I would probably be starting to cut back even further in year 3 to eke it out a bit longer.  I freely admit though that I arrived at this by thinking about how I would feel rather than by backtesting or other analysis!

[nereo]

I like the idea of coupling the withdrawal of a fixed percentage of portfolio with a cash buffer to smooth out part of the variability - eg a one year buffer would allow you to turn a 50% market crash into a 25% spending reduction for 4 years.  If that actually happened though I would probably be starting to cut back even further in year 3 to eke it out a bit longer.  I freely admit though that I arrived at this by thinking about how I would feel rather than by backtesting or other analysis!

Similar to a bond ladder with pre-determined withdrawal strategy based on recent market performance.  Sacrifice a small amount of growth potential in exchange for lower risk to SORR

[MustacheAndaHalf]

The stock market has recently had more dramatic up and down moves than normal - it's more volatile.  Retiring in that environment strikes me as more risky, because you don't know which direction stocks will take.

Most MMM forum members probably aren't planning on lavish spending in retirement - especially since retirement needs to last longer than for most people.  That means there's less room to reduce budgets, and that a varying amount of spending could be more difficult.

If someone is comfortable spending $40,000/year, and then March 2020 comes along, they might suddenly have to live on 2/3rds of that amount, or closer to $26,670/year.  And there's been worse downturns, where you might have to live on half.  That's the flaw with a fixed percentage withdrawal - it takes no notice of your rent and expenses.

[markbike528CBX]

....snip...

If someone is comfortable spending $40,000/year, and then March 2020 comes along, they might suddenly have to live on 2/3rds of that amount, or closer to $26,670/year.  And there's been worse downturns, where you might have to live on half.  That's the flaw with a fixed percentage withdrawal - it takes no notice of your rent and expenses.

So we insist that you take ALL of your 2020 withdrawals in March?   Year 2020 and March 2020 returns are two wildly different things. With a 6 month expenses fund, you might not have noticed March. 
Even for longer issues, a 1 year stash gets you through 90% of the market dips.

[PhilB]

...That's the flaw with a fixed percentage withdrawal - it takes no notice of your rent and expenses.

That's a very good argument for owning rather than renting in retirement.  Buying a property outright is equivalent to buying an indexed annuity, but much cheaper, certainly where I live.

I've only been spending 50% of budget through the pandemic, so it has been a pretty good proof of concept for me on variable withdrawal, but I freely admit I'm not at the lean end of FIRE.

[yachi]

I was just listening to an online talk by Wade Pfau (an expert on retirement planning) who made a fascinating claim about risk associated with sequence of returns made famous by the 4% rule [https://www.youtube.com/watch?v=0wrRSYsTbus&list=LL&index=2]. 

He claims (time stamp 59') that if, instead of regularly making 4% withdrawals adjusted for inflation regardless of how the market fares, you choose instead as your rule that you would limit your withdrawal each year to 4% of the total value of your portfolio, you could avoid the risk entirely. (The problem, as he sees it, is that most people are unable to/unwilling to dramatically alter their spending plans on a year to year basis depending upon the volatility of the market.)

This certainly makes sense - withdrawing 4% each year of what remains can be done indefinitely regardless of how the market fairs (unless all of your assets went to 0). But I'm wondering if I misinterpreted him.

The brilliance of the work that went into establishing the 4% rule, is it looked at the sequence of returns, and inflation, and bond returns, to answer the question:

Given that I don't want to change my lifestyle, how much of my retirement money can I spend?

Not allowing an adjustment for inflation means you are asking the retired person to modify their lifestyle.

Making the spending match a fixed percentage of your portfolio forces the retired person to spend like a maniac, amping up their spending in times of plenty (when others are doing it too), and slashing their spending in times of scarcity (when others are doing it too).  So you would, for example, put off replacing the roof in 2008 because your portfolio dropped, even though all the roofers are looking for work and you stand the best chance at getting a good price.  Then finally doing it in 2012 or whenever portfolios recovered only to find yourself competing with everyone else doing home repairs.

It's worse if you're looking at things like what type of car do you drive, and how far do you travel with it, how large of a house do you live in.  Answer these questions using 4% on a high year, commit to these expenses, then a low year come by and what do you do?  Sell the house and move?  Sell the car?  You'll probably end up cutting things like vacations.

[MustacheAndaHalf]

....snip...

If someone is comfortable spending $40,000/year, and then March 2020 comes along, they might suddenly have to live on 2/3rds of that amount, or closer to $26,670/year.  And there's been worse downturns, where you might have to live on half.  That's the flaw with a fixed percentage withdrawal - it takes no notice of your rent and expenses.

So we insist that you take ALL of your 2020 withdrawals in March?   Year 2020 and March 2020 returns are two wildly different things. With a 6 month expenses fund, you might not have noticed March. 
Even for longer issues, a 1 year stash gets you through 90% of the market dips.

You think March 2020 is the only downturn in history?  I said "there's been worse downturns", like the great depression wiping away 90% of wealth and lasting years.  The dot-com crash played out over 3 years... the 2008 crisis took several years until recovery.  So it's odd you're only planning for "market dips", rather than multi-year crashes.

[PhilB]

I was just listening to an online talk by Wade Pfau (an expert on retirement planning) who made a fascinating claim about risk associated with sequence of returns made famous by the 4% rule [https://www.youtube.com/watch?v=0wrRSYsTbus&list=LL&index=2]. 

He claims (time stamp 59') that if, instead of regularly making 4% withdrawals adjusted for inflation regardless of how the market fares, you choose instead as your rule that you would limit your withdrawal each year to 4% of the total value of your portfolio, you could avoid the risk entirely. (The problem, as he sees it, is that most people are unable to/unwilling to dramatically alter their spending plans on a year to year basis depending upon the volatility of the market.)

This certainly makes sense - withdrawing 4% each year of what remains can be done indefinitely regardless of how the market fairs (unless all of your assets went to 0). But I'm wondering if I misinterpreted him.

The brilliance of the work that went into establishing the 4% rule, is it looked at the sequence of returns, and inflation, and bond returns, to answer the question:

Given that I don't want to change my lifestyle, how much of my retirement money can I spend?

Not allowing an adjustment for inflation means you are asking the retired person to modify their lifestyle.

Making the spending match a fixed percentage of your portfolio forces the retired person to spend like a maniac, amping up their spending in times of plenty (when others are doing it too), and slashing their spending in times of scarcity (when others are doing it too).  So you would, for example, put off replacing the roof in 2008 because your portfolio dropped, even though all the roofers are looking for work and you stand the best chance at getting a good price.  Then finally doing it in 2012 or whenever portfolios recovered only to find yourself competing with everyone else doing home repairs.

It's worse if you're looking at things like what type of car do you drive, and how far do you travel with it, how large of a house do you live in.  Answer these questions using 4% on a high year, commit to these expenses, then a low year come by and what do you do?  Sell the house and move?  Sell the car?  You'll probably end up cutting things like vacations.

I very much doubt anyone would spend like a maniac just because the markets are up.  There is a big difference between spending a fixed percentage of portfolio value and withdrawing a fixed percentage.  As with anyone who has a variable income, retired or not, the sensible thing is to keep a reserve that you dip into in the bad times and top up in the good ones.

[nereo]

....snip...

If someone is comfortable spending $40,000/year, and then March 2020 comes along, they might suddenly have to live on 2/3rds of that amount, or closer to $26,670/year.  And there's been worse downturns, where you might have to live on half.  That's the flaw with a fixed percentage withdrawal - it takes no notice of your rent and expenses.

So we insist that you take ALL of your 2020 withdrawals in March?   Year 2020 and March 2020 returns are two wildly different things. With a 6 month expenses fund, you might not have noticed March. 
Even for longer issues, a 1 year stash gets you through 90% of the market dips.

I'm really curious about the "1 year stash gets you through 90% of the market dips" figure you cite here.  What is the threshold for market dips? How are we defining "getting through"? Under what circumstances does an ER use their 1 year cash-stach to 'get through' the dip?

I ask because holding a cash-position is in our strategy for SORR. From my analyses I'm not comfortable with just 1 year's holdings (currently I've settled at 3 years as being the best blend of safety and sacrificing future returns). 

[FLBiker]

Buying a property outright is equivalent to buying an indexed annuity, but much cheaper, certainly where I live.

I like this idea and I've never heard it put that way.  Thanks!

[ChpBstrd]

....snip...

If someone is comfortable spending $40,000/year, and then March 2020 comes along, they might suddenly have to live on 2/3rds of that amount, or closer to $26,670/year.  And there's been worse downturns, where you might have to live on half.  That's the flaw with a fixed percentage withdrawal - it takes no notice of your rent and expenses.

So we insist that you take ALL of your 2020 withdrawals in March?   Year 2020 and March 2020 returns are two wildly different things. With a 6 month expenses fund, you might not have noticed March. 
Even for longer issues, a 1 year stash gets you through 90% of the market dips.

I'm really curious about the "1 year stash gets you through 90% of the market dips" figure you cite here.  What is the threshold for market dips? How are we defining "getting through"? Under what circumstances does an ER use their 1 year cash-stach to 'get through' the dip?

I ask because holding a cash-position is in our strategy for SORR. From my analyses I'm not comfortable with just 1 year's holdings (currently I've settled at 3 years as being the best blend of safety and sacrificing future returns).

EarlyRetirementNow has some answers:

1) Of the ten corrections greater than 20% in the history of the S&P 500 prior to 2020, the mean time to recovery (total returns approach) was 16 months, with a median of 18 months. The 2020 correction lowered those stats.
2) Seven of the ten corrections (now 7 of the 11 corrections) lasted longer than 12 months.
https://earlyretirementnow.com/2019/10/30/who-is-afraid-of-a-bear-market/

3) Holding a cash emergency fund is sub-optimal 75% of the time.
https://earlyretirementnow.com/2021/05/26/the-emergency-fund-is-still-useless/#more-63393

[markbike528CBX]

....snip...

If someone is comfortable spending $40,000/year, and then March 2020 comes along, they might suddenly have to live on 2/3rds of that amount, or closer to $26,670/year.  And there's been worse downturns, where you might have to live on half.  That's the flaw with a fixed percentage withdrawal - it takes no notice of your rent and expenses.

So we insist that you take ALL of your 2020 withdrawals in March?   Year 2020 and March 2020 returns are two wildly different things. With a 6 month expenses fund, you might not have noticed March. 
Even for longer issues, a 1 year stash gets you through 90% of the market dips.

I'm really curious about the "1 year stash gets you through 90% of the market dips" figure you cite here.  What is the threshold for market dips? How are we defining "getting through"? Under what circumstances does an ER use their 1 year cash-stach to 'get through' the dip?

I ask because holding a cash-position is in our strategy for SORR. From my analyses I'm not comfortable with just 1 year's holdings (currently I've settled at 3 years as being the best blend of safety and sacrificing future returns).

EarlyRetirementNow has some answers:

1) Of the ten corrections greater than 20% in the history of the S&P 500 prior to 2020, the mean time to recovery (total returns approach) was 16 months, with a median of 18 months. The 2020 correction lowered those stats.
2) Seven of the ten corrections (now 7 of the 11 corrections) lasted longer than 12 months.
https://earlyretirementnow.com/2019/10/30/who-is-afraid-of-a-bear-market/

3) Holding a cash emergency fund is sub-optimal 75% of the time.
https://earlyretirementnow.com/2021/05/26/the-emergency-fund-is-still-useless/#more-63393

@ChpBstrd  Thanks for a better explanation and sources than I could have provided!  I engaged in a bit of hyperbole of 90% at 1 year.

@nereo
What is the threshold for market dips? - any decrease in market/portfolio that you notice enough to worry.
How are we defining "getting through"?  -recovery to approximately the market/portfolio before the dip.
Under what circumstances does an ER use their 1 year cash-stach to 'get through' the dip?  -  When the dip is large enough to cause you pain when you take cash out of an equity position.

"you" - the reader,  All the things mentioned above depend on your Investment Policy Statement (IPS), which you wrote _before_ the dip, the worry, the panic starts. Correct?

Note that even if your stash has gone to 50% of prior value, your "losses" compared to the prior high only apply to the portion you liquidate.
If you tend to be prone to 100% liquidation of equities during dips, then nothing I say will help.

Personal example:
I was worried that the uptick in by May 2020 might have been a dead-cat-bounce, so I sold VTSAX (Vanguard Total Stock Market Index) at about 11% lower than I could have gotten in February or September (the duration of the dip).
So I sold 11% low, it was only 16% of my withdrawals that year.

However, as I am a long term investor, the cost basis (breakeven) was only 39% of the withdrawal, so 61% gain for that transaction.

Edit: Sources: US 1040 form 8949 (supports Schedule D) and the Mark I eyeball on the chart https://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=VTSAX&insttype=&freq=1&show=&time=9


While I think 3 years cash is excessive (I only have about 1.5  years in cash/gold), that's not my concern, it is YOUR IPS and what helps you to not panic and not stray from your IPS.

This very forum had people go to full cash about March 2020 and announced that fact and gloated over the future loss (guaranteed in their minds) that they had avoided.
They also very cleverly avoided a 90% gain.

[yachi]

I was just listening to an online talk by Wade Pfau (an expert on retirement planning) who made a fascinating claim about risk associated with sequence of returns made famous by the 4% rule [https://www.youtube.com/watch?v=0wrRSYsTbus&list=LL&index=2]. 

He claims (time stamp 59') that if, instead of regularly making 4% withdrawals adjusted for inflation regardless of how the market fares, you choose instead as your rule that you would limit your withdrawal each year to 4% of the total value of your portfolio, you could avoid the risk entirely. (The problem, as he sees it, is that most people are unable to/unwilling to dramatically alter their spending plans on a year to year basis depending upon the volatility of the market.)

This certainly makes sense - withdrawing 4% each year of what remains can be done indefinitely regardless of how the market fairs (unless all of your assets went to 0). But I'm wondering if I misinterpreted him.

The brilliance of the work that went into establishing the 4% rule, is it looked at the sequence of returns, and inflation, and bond returns, to answer the question:

Given that I don't want to change my lifestyle, how much of my retirement money can I spend?

Not allowing an adjustment for inflation means you are asking the retired person to modify their lifestyle.

Making the spending match a fixed percentage of your portfolio forces the retired person to spend like a maniac, amping up their spending in times of plenty (when others are doing it too), and slashing their spending in times of scarcity (when others are doing it too).  So you would, for example, put off replacing the roof in 2008 because your portfolio dropped, even though all the roofers are looking for work and you stand the best chance at getting a good price.  Then finally doing it in 2012 or whenever portfolios recovered only to find yourself competing with everyone else doing home repairs.

It's worse if you're looking at things like what type of car do you drive, and how far do you travel with it, how large of a house do you live in.  Answer these questions using 4% on a high year, commit to these expenses, then a low year come by and what do you do?  Sell the house and move?  Sell the car?  You'll probably end up cutting things like vacations.

I very much doubt anyone would spend like a maniac just because the markets are up.  There is a big difference between spending a fixed percentage of portfolio value and withdrawing a fixed percentage.  As with anyone who has a variable income, retired or not, the sensible thing is to keep a reserve that you dip into in the bad times and top up in the good ones.

When Wade states the problem with his strategy is "most people are unable to/unwilling to dramatically alter their spending plans on a year to year basis depending upon the volatility of the market" then it's clear the intent of his strategy is that people match their spending plans to the volatility of the market.
I'm just trying to draw attention to the stupidity of behaving like he suggests.  It's discomforting to have to move from spending X to spending less than X, and his plan maximizes the amount of time you spend moving between different spending levels.  Like you I also believe it's sensible to keep a reserve, but moving money into the reserve is not a withdrawal from your portfolio, it's a rebalancing within your portfolio.  But I don't see evidence that Wade is suggesting that action.
There certainly are differences between spending and withdrawing.  One major, obvious difference is if you have earned income. 

[PhilB]

Like you I also believe it's sensible to keep a reserve, but moving money into the reserve is not a withdrawal from your portfolio, it's a rebalancing within your portfolio.

I know what you mean, but that's not the way I find easiest to think about it.  What I think of as my 'portfolio' is my perpetuity pot from which I intend to draw a fixed percentage for ever and eventually leave it to the kids.  I see that as totally ring fenced - it's for generating a (variable) income, not for spending and I generally shouldn't need to think about it - it basically replaces earned income.  I then have my reserves and other assets to largely be used to manage timing differences between my income and my spending - very much in the way that 'normal' people do when they are earning - at least the kind of people who save up for things rather than using credit!

It may well be more 'correct' or efficient to treat everything as one fungible portfolio.  I just find that more difficult both intellectually and emotionally than having separate pots for separate purposes which can each be managed according to purpose.  I have nothing but admiration for those who are able to get their heads around a 'one pot to rule them all' approach, I just find my way gives me a much easier life.

[effigy98]

With stimmies sequence of return risk is gone.

Sent from my Pixel 3a using Tapatalk

[TomTX]

I was just listening to an online talk by Wade Pfau (an expert on retirement planning) who made a fascinating claim about risk associated with sequence of returns made famous by the 4% rule [https://www.youtube.com/watch?v=0wrRSYsTbus&list=LL&index=2].

Wade has been writing biased, underhanded papers to discredit the 4% rule for many years. At this point, I wouldn't trust any analysis he produces. It's not worth the time to find what new way he handicapped the 4% rule.

Add in a management fee of 1% of assets, but don't count it as part of the withdrawal 4% and actually evaluating what is a 5% withdrawal? Yep!
Assume returns are 25% worse than any period in US history? Yep!

Those are the ones I remember off the top of my head.

[rudged]

Wade has been writing biased, underhanded papers to discredit the 4% rule for many years.

He's also written a book (How Much Can I Spend in Retirement) that provides a lengthy critique of the 4% rule. His primary critique is that Bengen's original analysis was based on the history of U.S. returns only. If you do a similar analysis of other returns for other countries for which we have historical data, the safe withdrawal rate falls to about 2%. (I suspect it is skewed by Japan, Italy and Germany, whose economies were completely devastated by WWII, compared to the U.S.)

[Simpleton]

I think withdrawing 4% of the REMAINING portfolio would work really well for people who undergo FAT FIRE.

Usually FAT FIRE has a large discretionary portion (like travel and leisure) which could easily be pulled back for 2-3 years if the market were to tank 50%.

I also think having the ability to work part time in retirement allows you to accomplish essentially the same safety net.