Asset Allocation Strategies To Attenuate Sequence of Returns Risk.

In the preceding post, I described the sequence of returns risk – the risk that you will get unlucky around the time you switch from accumulating money and starting to draw upon it.

Let’s say that we decide that we don’t want to take the chance of having an unlucky sequence of returns at our financial destination and potentially running out of money. Since the sequence of returns risk is magnified by volatility, one way to attenuate it is by reducing the volatility of our portfolio as the destination approaches and for a few years after.

How can we do that? What could the impact look like? What are the downsides?

How: add bonds to dampen volatility

It is common advice to add more bonds to our asset allocation as we age or if our risk tolerance decreases. We add those bonds to dampen volatility. Mid-duration government bonds may be particularly effective in this role. Because bonds still produce income and their price tends to move opposite to equity, the return is only slightly reduced by adding bonds, while the volatility is greatly reduced.

Using the Canadian Portfolio Historical Returns & Volatility Visualizer, moving from a 100% equity to a 60:40 equity:bonds portfolio attenuated the max historical drawdown from -30% to -15%. The potential downside of adding a higher bond allocation is that it does decrease the expected return slightly.

Comparing bond allocation strategies to reduce sequencing risk.

As mentioned, the biggest reason for holding bonds is to reduce our behavioral risk from volatility. If our risk tolerance from a behavioral standpoint is high, then a secondary consideration would be to reduce the sequence of returns risk.

If that secondary mathematical risk is the only reason why we are increasing our bond allocation and it is highest around the time of retirement, then it may make sense to simply increase bonds around that “risk window”.

How does a strategy of adding bonds just for that “risk window” compare to simply increasing bonds and leaving that higher bond allocation until death? Let’s model it.

Parameters for lucky vs unlucky sequence of returns simulation.

Cashflow: contributions and withdrawals

For a theoretical comparison, let’s take two investors. Both contribute $25K/yr to their portfolios for 30 years. They then withdraw $128K/yr for 30 years in retirement. Retirement will be labeled as year zero.

Returns

An all equity portfolio in our model returns a random annual return of +20%, +10%, and -10% while a 60:40 stocks:bonds portfolio randomly returns +12%, +7%, -5%.

Sequence of returns

These random returns are identical for both investors except for a 10-year window (5yrs before to 5yrs after retirement). During that “risk window”, the lucky investor gets good returns around retirement and experiences a bear market towards the end of the risk window. The unlucky investor has the same average returns, but their sequence has the poor returns around their retirement year and a bear market in their first year of retirement.

Two bond allocation strategies

Again, the stock:bond allocation should be primarily driven by investor risk tolerance. However, to make the simulation illustrative and simple, the two investors will either use 100% stocks or a 60:40 stock:bond allocation. They will simply flip allocations in a single year instead of the smooth transitions (like a glide path) that we’d see people use in real life. Taxes triggered by doing that are also ignored. This is to illustrate basic concepts and not get mired in the weeds.

The first strategy represents the conventional glide path of adding bonds as you approach retirement and then keeping that allocation. The second strategy is closer to a rising equity glide path. The rising equity glide path increases the equity allocation again after a few years of retirement when the sequence of returns risk window has hopefully past.

Conventional Strategy: add bonds and keep that allocation until death.

This would be common advice. The rationale is that we need to know that our money will be there when we need it. Since it is assumed that we can’t earn more income when we are old, we need predictable income from our investments. Bonds are a lower risk for loss of capital and they spit out regular income. Thinking of that regular income as different from simply selling periodically as needed to generate cash is mental accounting. However, that predictable and automated income generation is psychologically soothing and helps us to behave.

Unfortunately, the trade-off for the predictability of fixed income is that it is generally lower-risk and has a lower expected return. It is also intentionally taxed more than most other investment income. If we start to draw more than the income that our portfolio returns, then our capital will erode over time.

How do the lower sequencing risk and lower expected returns from adding bonds balance out?

Using the above model, the investors switch from an all-equity portfolio to a 60:40 split 5 years before retirement. They keep that until death 30 years later. If they are lucky, they run out of money a few years before dying. If they have an unlucky sequence of returns, then they are hitting the Fancy Feast for seven years before death.

There is a trade-off between decreasing expected returns and decreasing the sequence of returns risk from adding lower risk and less volatile investments. Once outside the window of the highest sequencing risk, the cause of running out of money can shift back to not having high enough returns over time. Most people need to invest to retire. If the portfolio size is small relative to the drawdown or the length of retirement is long – they need to invest aggressively enough to get sufficient returns to beat inflation and meet their cash flow needs.

Rising Equity Strategy: add bonds for the “sequencing risk window” only and then add equity back.

What if they invest more aggressively again as they pass the early stages of retirement when the sequence of returns risk lessens?

In the model below, our investors change from all equity to a 60:40 portfolio for a 10-year period (5yrs before until 5yrs after retirement). They then go back to the 100% equity portfolio. That reduces the return during that decade from 4.5%/yr to 3.5%/yr, but also cuts the volatility during that time in half (std dev 16.9% to 9.4%).

There are two important take-home messages from the above model.

First, neither investor ran out of money this time. However, this was still not without a trade-off.

The lucky investor ended up with $1.25M when they croaked. That still translates into lucky beneficiaries. However, if they had stayed with an all-equity portfolio for the entire time period, the would have had $1.75M.

Like the rest of investing, decreasing the sequence of return risk (if unlucky) also decreased the potential reward (if lucky). Since we don’t know the future, this comes down to the subjective decision of which risk is more important to you. Avoiding Fancy Feast while alive vs. leaving behind a smaller estate. My taste buds may fade with age, but I know what I would prefer.

Putting This Into Context

The strategy of increasing bonds when nearing the financial destination is pretty standard advice. However, ramping our equity allocation back up as we move further past that is not. Why is that?

Sequence of returns risk is a secondary consideration

The primary risk from volatility for most people is still likely to be behavioral risk. Only those with really high investing intestinal fortitude can tolerate the higher equity allocations where sequencing risk becomes a greater threat. Optimizing mathematical models and risks are meaningless if the emotional investor beast is in charge.

Running out of money becomes more frightening when we are retired and may not be able to simply earn more or spend less. Fear feeds the beast. On the other hand, if we make it past the “risk window” and it becomes obvious that we are likely to have more money than we need, that should alleviate fear. That would be logical, but emotions are not logical. The tipping point between these fears is definitely subjective and personal.

Strategy 3: Ignore Sequence of Return Risk

With behavioral risk being the primary consideration for most people, there is also a good argument for simply choosing the asset allocation that suits your emotional risk profile. Then, sticking with it throughout your lifespan. This is probably the most reasonable choice for most high-income professionals who will either have a risk tolerance requiring bonds anyway, buffer in their portfolio, and/or some flexibility with discretionary spending.

Sequencing risk has received increased attention recently because of the very early FIRE movement. Sequence risk is a major threat in that setting since the planning is often dependent on the high returns of equity and a low spending level that leaves little wiggle room over an extra-long retirement duration.

The above model was simple and extreme to illustrate the concept.

The above model may have scared some people. A 60:40 balanced portfolio is generally considered “safe”. Yet, in the above models, it ran out of money. That was not because of the portfolio per se. The portfolio returns were actually quite good. However, a mix of variables determines portfolio survivability.

In the above models, the ~$2M portfolios did not survive the strain put upon them if bad luck intervened. The portfolios failed to survive because the mix of the above variables aligned in the wrong combination.

In this model, the size of the portfolio was small compared to the drawdown rate. Putting away $25K/yr for 30 years for someone making $250K/yr is a 10% savings rate and enables after-tax spending of ~$140K/yr. Reducing spending slightly in retirement to $125K/yr is also seems reasonable. However, taking $125K/yr for 30 years from a $2M portfolio is a 6.25%/yr withdrawal rate. That is extreme.

Someone, starting to save later in life, like many professionals do, likely need to be more aggressive at saving (like a 20% savings rate) or plan on a more frugal retirement.

To get a more realistic sense of the range of possibilities, one must run thousands of simulations with different assumptions about the above variables. That approach (Monte Carlo simulation) generally yields a safe withdrawal rate in the 3-4%/yr range for historical return rates. It is probably even lower for longer retirements – like if you retire extremely early or live way past your best-before-date.

Portfolio volatility control is only half of the sequencing risk equation

In this post, we looked at mitigating the sequence of return risk by trying to lower volatility through adding bonds to a portfolio. That comes with the downside of decreasing expected returns which can also lead to portfolio failure. However, volatility is only part of the equation. Sequencing risk is caused when we have a combination of volatility and cash flows. In the next post, we’ll look at how to mitigate sequencing risk from the cash flow side of the equation.