Action Learning

Mitigating Sequence of Returns Risk (SORR)

T. Rowe Price Example Project

Background

Many individuals in the US rely on their workplace Defined Contribution (DC) Plan for funding spending needs in retirement.  During their working years, individuals make planned contributions into this workplace plan.  After 20, 30 or even 40+ years of contributions, they aim to fund their planned retirement horizon largely with assets saved through this plan.  As such, portfolio assets typically reach their peak in the years around retirement. 

However, as individuals retire and begin making planned withdrawals to fund spending needs, the typical balance begins to decline several years into retirement.  Meeting the spending needs of an unknown retirement horizon, although typically 20+ years in length, without running out of income-generating assets is the objective of these funds in retirement.

Adverse market events present headwinds to this objective.  It is precisely the interaction of adverse market conditions and planned withdrawals that can wreak havoc on the ability of the portfolio to continue funding planned withdrawals for the duration of retirement.  Without withdrawals, adverse market conditions cause a "paper loss" if the portfolio subsequently rebounds.  However, withdrawals taken when the portfolio has temporarily decreased in value permanently inhibit the portfolio's future sustainability objective.  This phenomenon is commonly referred to as Sequence of Returns Risk (SORR).  The adverse market returns, particularly those that occur early in retirement when balances are largest, coupled with planned withdrawals, can adversely affect retirement success.  

Pfau (2013) illustrates that losses experienced in the first several years in distribution are the most detrimental.  He estimates that 77% of the final retirement outcome can be explained by the average return of the first 10 years of retirement.

Project Description

Many DC investors use a Target Date Fund as their primary investment strategy.  These strategies are designed to de-risk into retirement in order to mitigate SORR.  The industry average glidepath is attached.  For this project, assume that the industry average glidepath is the baseline investment strategy.  Your goal is to propose ways to improve upon this strategy in order to further mitigate SORR. 

What is the mechanism by which your proposed strategy or approach further addresses SORR?  Which approaches are most effective? While we provide daily S&P 500, 5-Year Treasury constant-maturity and 30-day T-bill returns since 1960, feel free to use other return series if they are helpful.  In addition to an investment strategy, you will need to assume a withdrawal strategy for the portfolio.  The withdrawal strategy should be constant (in terms of $ amount, not % of portfolio assets) regardless of assumed investment strategy.  Use the literature to find methods to measure the degree of SORR with and without your investment strategies.  Alternatively, create your own measurement/assessment framework.