Hedging against Sequence Risk through a “Retiree-Saver Investment Pact” – SWR Series Part 53
June 6, 2022
In this year’s April Fool’s post, I marketed a made-up crypto coin that would completely hedge against Sequence Risk, the dreaded destroyer of retirement dreams. Once and for all! Most readers would have figured out this was a hoax because that complete hedge against Sequence Risk is still elusive after so many posts in my series. Sure, there are a few minor adjustments we can make, like an equity glidepath, either directly, see Part 19 and Part 20, or disguised as a “bucket strategy” (Part 48). We could very cautiously(!) use leverage – see Part 49 (static version) and Part 52 (dynamic/timing leverage), and maybe find a few additional small dials here and there to take the edge off the scary Sequence Risk. But a complete hedge is not so easy.
Well, maybe there is an easy solution. It’s the one I vaguely hinted at when I first wrote about the ins and outs of Sequence Risk back in 2017. You see, there is one type of investor who’s insulated from Sequence Risk: a buy-and-hold investor. If you invest $1 today and make neither contributions nor withdrawal withdrawals, then the final net worth after, say, 30 years is entirely determined by the compounded average growth rate. Not the sequence, because when multiplying the (1+r1) through (1+r30), the order of multiplication is irrelevant. If a retiree could be matched with a saver who contributes the exact same amount as the retiree’s cash flow needs, then the two combined, as a team, are a buy and hold investor – shielded from Sequence Risk. It’s because savers and retirees will always be on “opposite sides” of sequence risk. For example, low returns early on and high returns later will hurt the retiree and benefit the saver. And vice versa. If a retiree and a retirement saver could team up and find a way to compensate each other for their potential good or bad luck we could eliminate Sequence Risk.
I will go through a few scenarios and simulations to showcase the power of this team effort. But there are also a few headaches arising when trying to implement such a scheme. Let’s take a closer look…
Introducing the RSIP: a Retiree-Saver Investment Pact
We’d need to pair up a retiree and a saver or groups of retirees and savers whose cash flows exactly cancel out each other. Then at the end of the contract period, both retiree and saver will receive a respective portfolio value they would have achieved had the return pattern been one flat monthly or annual return matching the CAGR during the contract period, i.e., in the absence of Sequence Risk.
Imagine, for simplicity, that we have a retiree with a $1m initial portfolio with $40,000 in annual cash flow needs and a retirement saver who starts with a $0 portfolio and saves $40,000 annually. Assume that they agree to offset each other’s cash flows over a set contract period to generate a buy-and-hold investor if aggregating the two cash flows. For any realized buy-and-hold investor CAGR over this period we can now calculate the final values of the retiree and saver portfolios using the Excel future value (FV) function:
=FV( CAGR ,Nyears , 40000,-1000000,1) (retiree) =FV( CAGR ,Nyears ,-40000, 0,1) (saver)
And again, notice how the final values depend solely on the CAGR. Not on the Sequence of Returns! In any case, before we even get into any simulations, let’s run a simple example to warm up. Imagine both retiree and saver like to eliminate Sequence Risk over a 10-year horizon. They may each have a longer horizon, but they decide to sign this pact over a 10-year horizon, so bear with me.
Let me first illustrate the workings of Sequence Risk again. Let’s assume that over the 10-year horizon a portfolio of risky assets returns 5% (inflation-adjusted) on average, measured by the CAGR. Let’s assume that returns can be High (+29.71%), Moderate (5%), or Low (-15%). Why that crooked number of 29.71%? Simple, that ensures that one high and one low return combined get you back exactly to 5% CAGR. Check the math if you like: 1.2971*0.85=1.1025=1.05^2! Now let’s look at 7 different sequence risk scenarios. We can start with the “MMM” scenario where we have flat 5% returns every year, plus 6 additional scenarios: each with 6 years of moderate returns, 2 years of high, and 2 years of low returns in varying orders. Notice again that all 7 scenarios have the same CAGR: