Welcome to this week's video blog made in conjunction with The Wealth Channel at the American College. Today I provide a discussion of Jonathan Guyton's recent Journal of Financial Planning column, "Sequence-of-Return Risk: Gorilla or Boogeyman?"
For email readers, the videos never show up in the email, but you can see the video by clicking here.
What now follows is not an exact transcript. It is the written version of what I meant to say above, though as I was not reading from a script, I sometimes veered away from the plan when speaking:
Jonathan Guyton Tames a Gorilla
In the October 2013 Journal of Financial Planning, Jonathan Guyton asks the question: is sequence of returns risk in retirement an 800-pound gorilla posing a great threat to even the best-laid retirement plans, or is it only a boogeyman which can effectively be avoided. His conclusion is that sequence of returns risk may be more of a boogeyman.
To provide a little background, sequence of returns risk is experienced by those seeking to fund a constant expenditure goal from a volatile portfolio. When the portfolio drops, a greater percentage of assets must be spent to achieve the desired spending amount, permanently removing these assets from the portfolio and making it extra difficult for the portfolio to fully recovery. The specific returns experienced in the first years of retirement explain a disproportionate amount of the final retirement accounts.
However, as I outlined in a recent blog post about lifetime sequence of returns risk, two effective strategies for dealing with sequence of returns risk are either to reduce spending when the portfolio declines or to use a less volatile portfolio.
In his article, Jonathan Guyton focuses on both of these approaches in the first study I am aware of which combines a valuation-based asset allocation study with a dynamic withdrawal strategy. On the asset allocation side, he uses a globally-diversified portfolio with a “normal” allocation of 65% stocks.
When markets are sufficiently overvalued or undervalued with respect to the Shiller cyclically-adjusted price-earnings ratio, he will modify the stock allocation to 50% (when overvalued) or to 80% (when undervalued). Historically, large stock market drops tend to happen from points of overvaluation, and so this strategy aims to eliminate some of the downside, and therefore reduce the impact of sequence risk.
As for the dynamic spending strategy, Guyton applies the spending decision rules that he developed and tested with William Klinger in the Journal of Financial Planning. These rules stop an inflation-adjustment for spending after years when the market declined in value, and also sets thresholds to either increase or decrease spending by 10% when the withdrawal amount as a percent of remaining financial assets deviates outside of a 20% range from the initial withdrawal level. When it comes to dynamic spending strategies,
I have tended think in terms of David Blanchett’s mortality-updating constant probability of failure approach, but at the recent FPA Experience conference, well-respected and influential planner Dave Yeske chided me for not paying enough attention to the Guyton and Klinger decision rules. These rules may be more practical and easy to understand, and therefore will be more usable in the real world, even if they are not fully optimal at a theoretical level. Any approach which reduces spending after market drops does also help to alleviate sequence risk.
[Note: since first writing these paragraphs, I wrote a column about variable spending strategies for Advisor Perspectives and came away from that with much greater respect for the Guyton and Klinger decision rules.]
Nonetheless, we now have a framework for using both dynamic asset allocation and dynamic spending rules.
Jonathan Guyton then applies this to the case of a hypothetical 2000 retiree over the first 14 years of their retirement. He finds that with this dynamic approach, the 2000 retiree could have started with a 5% withdrawal rate with a spending freeze in 2001 and cuts in 2002 and 2008, and still see their portfolio balance to have grown by the start of 2013. Compared to a static strategy with a 4% initial withdrawal, the dynamic approach supported both higher total cash flows for spending as well as a larger remaining portfolio balance. These are very impressive results which suggest that sequence of returns risk is a beast which can potentially be tamed.