Between 2009 and 2020, advisors didn’t have to worry about this particular risk, though they didn’t know it at the time. Longevity risk was far and away a more common topic of conference sessions during the extended bull market.

But the current economic and market environment is more uncertain, and industry experts, regardless of what they espouse to be a safe withdrawal rate, have been agreeing that there are more signs out there that the American retiree is more vulnerable today to sequence risk than in the recent past. While there are no ironclad predictors that a new class of retiree will be dealing with the pain of sequence risk, there is agreement that high P/E ratios are a leading indicator that the risk is high, and in particular the cyclically-adjusted ratio developed by Nobel laureate Robert Shiller of Yale University in 1996, known as the Shiller P/E ratio.

Shiller’s ratio is considered by some experts to be a better market valuation measure than the P/E ratio investors use because it strips out fluctuations due to the variation of profit margins during business cycles. “The P/E measures that are often used in investment markets for investment decisions may be fine for investment decisions, but it turns out they’re not nearly as predictive of retirement sustainable spending,” Kitces explains.

In particular, he uses a 10-year average of the Shiller P/E ratio to create a snapshot of the current level of likelihood for sequence risk. And that’s about it.

“There have been a couple of studies over the years that have tried to draw a link to interest rates being an additional factor, but most of them either have not been terribly conclusive or haven’t really shown more predictive value than market valuations,” he says. “Sequence risk comes from stocks simply because they are the things that are volatile and could have such long-term periods of potential underperformance.”

The upshot is that today is a much worse time to retire than it was 10 years ago when you take into account sequence-of-returns risk, he says. “That’s what the data would tell you.”

Mitigating Risk With Rightsized Spending
Although technically the 4% rule is robust enough to get retirees through the likes of the Great Depression and the high-inflation 1970s, augmenting this approach with “guardrails” can provide the same downside protection while actually increasing what retirees can spend in retirement.

And this is one area where Kitces and Rekenthaler agree right off the bat. In fact, Morningstar’s latest safe withdrawal report dedicated nine pages to research looking at how an effective guardrails system—where retirees get a raise when the markets do well but rein in their spending when the markets don’t—can support higher safe withdrawal rates at the beginning of retirement, result in higher lifetime withdrawal rates, and still leave some assets for the bequests.

“The best approach would be to split up the portfolio, get some part of it devoted to guaranteed income, and then be flexible with the remaining portion,” Rekenthaler says. “The way to get higher withdrawal rates over time during retirement is to be flexible and to respond to market movements.”

That flexibility would start, according to Morningstar, with a safe withdrawal rate of 5.2% that gets adjusted annually according to portfolio performance and the previous withdrawal percentage. If the market is trending upward and all criteria are met, the retiree would get a 10% increase on top of the inflation-adjusted prior-year withdrawal.

But if the market is dropping and the reverse happens, the retiree would cut the annual withdrawal by 10%. “I’m a fan of the guardrails kind of approach,” Kitces agrees. “Looking at this in practice with retirees over the years, I see that people can make some adjustments. We don’t like making big adjustments, and we don’t like making a lot of adjustments. But if I spend less in down markets, it turns out that helps my sequence-of-returns risk. Because I’m spending less when the markets are down, that helps to smooth the path.”

Plus, this approach takes human behavior into consideration: When the headlines scream “financial crisis,” people tend to respond by slowing their spending.

“Guardrails just acknowledge the reality of what we already do,” Kitces says. “But it turns out, if you actually consider that in your planning, it does let you spend a little bit more up front if you’re willing to make some adjustments as you go.”

First « 1 2 » Next