Attempting to sustain a fixed living standard using distributions from a portfolio of volatile assets is an inefficient retirement income strategy. This is a unique source of sequence risk. Four general techniques for managing sequence risk in retirement are highlighted in this article.
1. Spend Conservatively
The first option for managing sequence risk in retirement is to spend conservatively. Retirees want to keep spending consistent on an inflation-adjusted basis throughout retirement. With a total-returns investment portfolio, an aggressive asset allocation provides the highest probability of success if the spending level is pushed beyond what bonds can safely support and if annuities are not otherwise considered. The primary question with this strategy is how low spending must be to ensure a sufficient probability of success. Combining an aggressive investment portfolio with concerns of outliving your assets means spending must be conservative.
Ultimately, fearful retirees may end up spending less with an aggressive investment strategy than they might have had they focused more on fixed-income assets. This aggressive portfolio/conservative spending strategy can be rather inefficient, as the safety-first school argues that there is no such thing as a safe spending rate from a volatile investment portfolio. While this approach seeks to mitigate sequence-of-returns risk, it can actually increase it, as there is no lever to provide relief after a market decline. The only solution is to sell more shares to keep spending consistent.
2. Maintain Spending Flexibility
The next approach keeps the aggressive investment portfolio of the prior strategy while allowing for flexible spending. Sequence risk is mitigated here by reducing spending after a portfolio decline, thereby allowing more to remain in the portfolio to experience any subsequent market recovery. At the extreme, Dirk Cotton demonstrated at his Retirement Cafe blog that a strategy of withdrawing a constant percentage of remaining assets eliminates sequence-of-returns risk. Just like investing a lump sum of assets, the order of returns no longer matters.