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:

7 Sequence Risk scenarios, each with a 5% CAGR.

We can briefly confirm that a buy-and-hold investor achieves the same final net worth regardless of the order of returns. Here’s a chart:

Balances of the Buy&Hold investor.

And below is a table with the same information. Notice again that the final value has to match up exactly, even though the path over time can be very different:

Balances of the Buy&Hold investor.

While the buy-and-hold investor is shielded from Sequence Risk, the retiree will certainly not be indifferent to the sequence of returns. Here’s a time series chart of the retiree, starting with a $1,000,000 portfolio and withdrawing $40,000 each year (at the beginning of the year). Notice that the balances are plotted before the withdrawals. So X(0) = $1,000,000 and X(t)=[X(t-1)-$40,000]*[1+R(t)], t=1,…,10.

Now we get some action! The final balances range from $887k to $1.244m. The most advantageous scenario is when the high returns hit first and the low returns come last, and vice versa – no surprise here!

Balances of the retiree.

The same info is in the table below. Notice how this retiree’s IRR can be significantly different from the realized CAGR, all due to Sequence Risk. If a retiree had committed to this RSIP contract, he or she would be guaranteed to walk away with $1,100,623 after 10 years, regardless of the sequence of returns. So, for example, under the HML scenario, the retiree would give $143,578 (=$1,244,201-$1,100,623) to the saver. But in the worst-case LMH scenario, the retiree would receive $213,333 ($1,100,623-$887,291) from the saver.

Balances of the retiree.

Now the same exercise for the saver:

Balances of the Saver.

And all that again in a table format below. Notice how the range of IRRs is even wider for the saver (makes sense due to the $0 initial balance). It’s quite intriguing how merely reshuffling the order of returns will transform a 5% CAGR into anything between a -0.71% to +10.98% IRR. The best-case scenario (LMH) gives you almost a 2x relative to the worst-case scenario (HML). All due to Sequence Risk!

Balances of the Saver.

And just to confirm, the payments are now exactly flipped: In the HML scenario, the saver would receive $143,578 from the retiree, while in the LMH scenario, the saver would pay $213,333 to the retiree. This would exactly guarantee a $528,271 payout for the saver, regardless of the sequence of returns. Pretty cool!

Summary so far: If a saver and retiree could sign a binding contract to balance their portfolios back to the “MMM” scenario, i.e., flat returns equal to the realized CAGR, then we could certainly take a bite out of Sequence Risk. It’s also important to note that it’s not just the retiree who would benefit from this scheme. Savers face significant Sequence Risk. In other words, to all of us who retired recently, let’s not get too cocky. Our investment success is mostly due to luck in the form of both high average returns and a very advantageous Sequence Risk outcome: low in 2008/9, moderate for a few years, and then spectacular in the latter part, especially in 2019/2020/2021. The next cohort of savers may not be so lucky and can certainly benefit from such a scheme!

Simulations with Historical Data

Let’s run some historical simulation with actual return data 01/1871-04/2022. Let’s assume again that the initial portfolios are $1m for the retiree and $0 for the saver and the annual withdrawals of $40,000 exactly offset the annual contributions of the saver. To be consistent with my other SWR work, I assume that we run this at a monthly frequency (=$3,333.33 of monthly withdrawals/contributions). The time horizon is 30 years and the retiree has a 75% stock, 25% bond portfolio (intermediate 10-year U.S. Benchmark Treasury bonds). The account values and withdrawals/contributions are adjusted for inflation, as always.

Let’s first look at the final outcome the retiree could achieve without the scheme, i.e., when subject to Sequence Risk (blue dots) and with the RSIP, i.e., when hedging the Sequence Risk (orange dots) in the chart below. Luckily for the retiree, even at the lowest 30-year CAGR, you would not have run out of money. But without the RSIP there were plenty of occasions where you would have depleted your portfolio. Intriguingly, the retirement bust scenarios occur when the 30-year CAGR of the buy-and-hold 75/25 portfolio was between about 3.8% and 6.5%. This confirms again that Sequence Risk is a much larger headache than merely low average returns. Over a 30-year horizon, you need a mere 1.3% flat real return to exactly deplete your portfolio. That’s a low bar. All the retirement failures are squarely due to Sequence Risk, not the CAGR falling below 1.3%!

Final Value (in $1m) of the retiree after 30 years of withdrawals, $3,333.33 per month. 75/25 portfolio. Balances and withdrawals are CPI-adjusted.

And the same for the saver, see below. Clearly, the saver will not run out of money but look again at the dispersion of the blue dots around the orange line: Several million dollars in final value uncertainty. A lot of retirement savers may be willing to give up the upside to hedge the downside risk. Give up the prospect of a $7m retirement portfolio but vastly reduce the possibility of falling short of $2m.

Final Value (in $1m) of the saver after 30 years of withdrawals, $3,333.33 per month. 75/25 portfolio. Balances and withdrawals are CPI-adjusted.

Instead of plotting the final values, we can also calculate the IRR for the different retirement and saver cohorts. Excel has a neat function for translating a present value (PV), a future value (FV), and regular payments into an IRR.

=(1+RATE(360,0.04/12,-1,FV,1))^12-1    (retiree)
=(1+RATE(360,0.04/12,0,-FV,1))^12-1    (saver)

Notice that I run this at a monthly frequency, so the payments are 0.04/12, but then the IRR has to be annualized.

Let’s plot this for the retiree first, see below. I plot the actual retiree cohort IRRs (blue dots) and also a 45-degree line because that 45-degree line is the IRR you could have gotten with the RSIP, i.e., in the absence of Sequence Risk.

Again: you win some, you lose some. The blue dots are scattered wildly around the CAGR. For example, this chart demonstrates how Sequence Risk can turn a 6% CAGR for the buy-and-hold investor into a -1% IRR for a retiree. By the way, this cohort with the -0.73% IRR is the December 1968 cohort. The average return from December 1968 to December 1998 was an impressive 6.02% (real). But due to Sequence Risk, the retiree got shafted with a negative IRR (while the Dec 1968 saver cohort got a +9.30% IRR!).

IRR of the retiree. $1m initial value, $3,333.33 monthly withdrawals, 30 years horizon. 75/25 portfolio. Balances and withdrawals are CPI-adjusted.

And the same for the saver, see the chart below. Again, we get a wide dispersion of IRRs around the 45-degree line. The historical range of IRRs ranged from 1.5% to 9%, while the realized IRRs of the saver ranged from -0.5% to just under 10%.

IRR of the saver. $0 initial value, $3,333.33 monthly contributions, 30 years horizon. 75/25 portfolio. Balances and withdrawals are CPI-adjusted.

Challenges

At first glance, this seems to be an easy way to accomplish a hedge against Sequence Risk. Hey, maybe we could run our own little FIRE quasi-pension fund. But the devil is in the details. Here are a few headaches I can think of:

Asset allocation: Savers and retirees may not want to hold the same asset allocation. For example, fresh retirees will likely opt for a slightly more conservative asset allocation, maybe about 75% stocks and 25% diversifying assets like longer-term bonds and/or short-term fixed income instruments, while young savers might want to be more aggressive. That’s not really an insurmountable obstacle because if young savers prefer 100% equities then the retirees may then contribute only their equity portfolio to the pact. And maybe construct a bond ladder to supplement the retirement income.

Horizon: retirees and savers might have different time horizons. For traditional retirees (30-40 years horizon) and retirement savers (also a 30-40 years horizon), this might all work really beautifully. But in the FIRE community, we have this slightly lopsided distribution: maybe 10-15 years of accumulation and then 40-60 years of retirement. Of course, one retiree cohort could always be paired with a new set of fresh FIRE savers once the current one archives financial independence. But the problem with this idea is that in order for the RSIP to work we’d need to ensure that the duration of the pact is long enough that a long stretch of bad returns can be offset by a new bull run. 10-15 years might not be enough. There were plenty of poor return windows for the stock market: 1929-1942, 1965-1982, 2000-2009 when a 10-15 year window would have been too short to effectively hedge against sequence Risk. You would have needed the subsequent 10-15 years to truly smooth out that Sequence Risk. 20-30 years seems to be the minimum to capture enough of a large macrocycle to include both poor and blockbuster returns.

Maybe the solution would be to pair traditional retirement savers with a 30-40-year horizon with FIRE enthusiasts and cover their first 30-40 years in retirement. FIRE savers with their short horizons may be less-than-ideal candidates for this scheme.

Taxation: The flows between two parties in this pact will likely draw the attention of the IRS. How do we tax the transfers from one group to the other? Capital gains? Ordinary income? How do we deal with the cost basis in taxable accounts? My suspicion is that this plan would work best if we implemented it in a retirement account where we don’t have to deal with a lot of the taxation issues of reshuffling assets.

Safety: Before I hand over any sum of money I’d need to see some assurances that people won’t abscond with my hard-ERNed cash. We could implement this RSIP through a reputable financial institution, think Fidelity or Vanguard. Or an insurance company. Or maybe this is a blockchain application where we could cut out the greedy financial companies and do this peer-to-peer start-to-finish. Some silicon valley whiz-kids might want to take a shot at this!

Commitment: Both parties – saver and retiree – will initially enter this pact voluntarily and willingly, because on an ex-ante basis it is advantageous to hedge against risk. But people might regret this pact ex-post after the asset returns have come in. No, let me correct this, exactly one side of the deal will most certainly regret participating in the deal. Because that’s the whole idea of this peer-to-peer insurance contract: one side’s gain is the other side’s loss. We only enter this insurance contract because we believe that there could be some large net payments and ex-ante we prefer to minimize the risk. If I find out, ex-post, that Sequence Risk helped my portfolio, I’d rather run with my money instead of sharing some of the Sequence Risk gains.

And this commitment problem is worse for the saver who needs to contribute the regular flows. Maybe institutional investors like pension funds could take the side of the saver. That would be a challenge again, though, because it would have to be a “young” pension fund with mostly savers and very few retirees and thus net inflows. The current pension fund landscape is the exact opposite: most companies have phased out their defined benefit plans and replaced them with defined contribution plans. The existing pension funds still around are mature funds with mostly aging beneficiaries and net outflows. Not much help there!

Also, the willingness for continued participation is not always the biggest problem. There’s also an issue with the ability to participate: This is less of an issue for the retiree who simply sits back and collects $40,000 checks every year. But a huge concern for the saver. What if savers lose their job, die, or become disabled?

Retirement ruin: Even though both parties hedge against sequence risk, there is no insurance against the average realized asset return. If the average equity return is low enough then the retiree can still run out of money. Historically, there would have been a few cases where a $40,000 annual withdrawal would have wiped out a 100% equity portfolio even with the RSIP.

Summary so far: Maybe this RSIP is mostly a cute theoretical construct but not so easy to implement. I’m open to suggestions for how to make this work in real life. Please use the comments sections if you want to help.

But maybe we could implement transfer payments without a specific counterparty. This brings me to the next point…

Can I self-insure against Sequence Risk using a time-varying asset allocation and/or derivatives?

Is it possible to generate the sequence-contingent transfer payments just on my own? Without any direct counterparty that may or may not be willing to adhere to the multi-decade investment pact? One way would be to devise a derivative-based strategy to at least roughly mimic the transfer payments between the retiree and the saver. The advantage of this approach is that many of the headaches listed above will go away. For example, if I were to generate transfer payments modeled after this strategy through exchange-traded derivatives I would not have to worry about my counter-party walking away from the deal. (well, there is a minute risk of both the counterparty and the exchange going belly-up simultaneously, but let’s not even go there…)

Taxation would also become a lot clearer: Index futures and options enjoy tax-advantaged treatment under IRS Section 1256, as my readers know from my options-trading posts. One obstacle, though would be that, some options strategies may work only in taxable brokerage accounts, not in retirement accounts!

There may be many different ways to structure this, but the most obvious one is this: Imagine a retiree expects a target real return of 4% p.a. over a 30-year horizon and a 4% annual withdrawal rate. And for this simple example, I go back to annual withdrawals, taken at the beginning of the year.

Imagine that in year 1, this retiree suffers a 10% drop in the portfolio. Assuming that during the remaining 29 years we revert back to the 4% target we can project the portfolio’s final value. That’s what I did in the table below. The retiree is expected to end up with $491,117 (in real, inflation-adjusted dollars). If the retiree had access to the RSIP, SoRR insurance we can calculate the 30-year CAGR as 3.50%, i.e., CAGR of one year of -10% and 29 years of 4% return. The projected final portfolio value in the absence of Sequence Risk, i.e., with a fixed 3.5% rate of return, is $669,611. So, if you had access to Sequence Risk hedging you’d stand to get a transfer of $178,494 in year 30. Discounting this payment back to year 1 at an annual rate of 4% would amount to $57,234.

Project the final balance of a retiree after a -10% return in year 1.

We can also calculate this transfer payment for several different Y1 returns. Let’s calculate the transfer payment for Y1 returns of -15%, -10%, -5%, 0%, 4%, 10%, 15%, 20%, and 25%. Obviously, the transfer has to be zero for the Y1 return of 4%, but it’s good to confirm and check the math. I plot the scatter plot of the Y1 return (x-axis) vs. the transfer payment (y-axis) in the chart below:

Y1 return (x-axis) vs. Y1 transfer (y-axis) needed to compensate for Sequence Risk.

That line is almost a perfectly straight line. That’s not too surprising because even though the future value after 30 years is a non-linear function, by taking the difference between the two versions, once with and once without SoRR, we generate a function almost exactly straight. This particular line has a slope of about -$400k and an intercept of just under $17k.

So, how could we replicate this blue line with a derivatives strategy? It’s not that easy! We could certainly sell a futures contract with a notional of $400,000. But we wouldn’t be able to get the $17,000 intercept.

Likewise, we could sell $400,000 of the risky assets to exactly replicate the slope of the blue line. But in taxable accounts that might become a big headache from a taxation perspective given our progressive income tax function. And even in tax-deferred accounts, selling assets is useless unless we find a safe investment with a 4.25% return (17,000/400,000=0.0425=4.25%) to shift the line up to its intercept. I-Bonds currently yield 0% above inflation, TIPS also around 0%, and nominal bonds around 2.1% for one year, which will likely get you to -4.25% rather than +4.25% after inflation. Not a pretty sight! In fact, if we had access to a 4.25% safe return, we wouldn’t have to worry about Sequence Risk and hedging against an uncertain Y1 return, would we? We would just move the entire portfolio to that asset, raise the withdrawal rate to 4.25%, always preserve our portfolio, and live happily ever after.

One could argue that after a big drop in the stock market, we’d likely also expect slightly higher returns return in years 2-30, from a valuation point of view. By discounting at a higher rate we might be able to push that intercept down a bit. But not by much. Not by enough to bring the required return down to the 0% real return we face today.

Conclusions

I guess the perfect solution to Sequence Risk is still elusive. The RSIP is a cute theoretical and mathematical concept but implementing it directly through a retiree plus saver partnership faces a lot of obstacles. On the top of the list is the commitment problem of the saver. Maybe an insurance company or large brokerage company could take the counterpart and offer Sequence Risk insurance to retirees. But I’m concerned that the fees involved would likely wipe out any potential gains. Trying to implement a transfer payment scheme through a derivatives strategy is also an uphill battle. But I’m open to suggestions. Please share in the comments section if you have better ideas on how to make this work!

Thanks for stopping by today! Please leave your comments and suggestions below! Also, make sure you check out the other parts of the series, see here for a guide to the different parts so far!

Title Picture credit: pixabay.com

48 thoughts on “Hedging against Sequence Risk through a “Retiree-Saver Investment Pact” – SWR Series Part 53

  1. Mortality of the retiree (like that if the saver) is a potential problem – how sophisticated a contract is needed to protect the saver from claims on the assets of the retiree while alive or their estate thereafter? Will the retiree’s heirs challenge the validity of the contract in cases that the sequence began above average and the retiree passes away before completing their obligation? Can the risk be spread among more savers and retirees instead of a one to one contract, and isn’t that what social security or other national plans already attempt or annuities seek to profit from? Great article!

    1. Mortality is “a” problem but not a very bad one. The main commitment problem is on the saver’s side, as outlined in the post. If the retiree dies the heirs would take over the remaining payments of the contract, i.e., monthly/annual contract payments plus the portfolio at the end of the period.

      Not too different from an annuity with a guarantee period.
      If the retiree signed the contract the heirs will have no legal leverage. Same as in the case of an annuity.

      1. It really is social security or a pension fund though…why even start with investments? If the saver would fulfill their end of the contract and then immediately enter the same contract with retiree status, what’s the point of the assets in the first place? It’s just to replace the fact that, by hypothesis, the retiree didn’t have the status of a saver in the arrangement you describe. The retiree has to “buy in” to the arrangement. But if every retiree is required to participate, a broad-based social security or pension system does exactly what you’re describing without buying in through assets. This article is a giant argument for compulsory social security/pension systems.

        1. No it’s not. Social Security has zero investments.
          In a pension fund, if a retiree dies, the “savings” are gone, while in my setting, the retiree can leave assets to their loved-ones.
          Also, most people don’t even have access to a PF. Even IFy ache resembled a PF, this would be a way to replicate something most people can’t get.

  2. A very interesting concept indeed. Thank you for sharing your great ideas and effort, ERN!

    However, implementation seems to be a bit challenging. Are you thinking about developing a service out of it?

    I think in the meantime likewise attractive but better feasible products for completely your own investments are available. They can also balance the wildly changing returns in good and bad times through better diversification with contrarian investments, such as stocks, real estate, trend following and long volatility.

    Even though their challenge is the investor mindset as well to accept underperformance vs. the stock market for long times. This may be even more acceptable if it is offered in blended format.

    Thus,the novel offers I refer to are expected to provide centuries of smooth returns:

    US:
    Cockroach Portfolio – https://mutinyfund.com/
    Dragon portfolio – https://www.artemiscm.com/
    Standpoint Multi-Asset Fund – https://www.standpointfunds.com/
    Abraham Fortress Fund – https://www.abrahamtrading.com/performance (real track since 2008 already)

    In parallel to the first two but not knowing all four in the beginning, I also developed such a strategy with my team and put it on the European market at beginning of last year:
    Democratic Alpha – https://www.democratic-alpha.com/ (sorry, only English machine translation available)

    Here is my whitepaper on Linkedin with tons of literature processed (the official one is in process):
    https://www.linkedin.com/post/edit/6845120443960070144/

    Maybe interesting for your community? This may even be interesting with your approach with more steady returns as head start?

    Best,
    Norbert

    1. Thanks for the links.
      CTAs were all the rage in the 2000s. Then they had a terrible run since then. But with an inflation shock we might get a fruitful environment again for such strategies.

      1. Yes. According the 137 years longterm simulation study under very realistic assumptions, the decade from 2010 on was the third worst of all 14: A Century of Evidence on Trend Following Investing https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2993026

        However if staring at the last peak before GFC at the end of 2007, you would not have done much worse at the last peak at the beginning of this year. As returns of informed trend following have been about the same as of equities with its ups and downs over the decades, but not only not correlated but contrarian, it is advantageous to also buy and hold TF MFFs as core asset class besides stocks and real estate.

        I do it 50/30/20, thus eliminating the max. drawdowns in crises and SoRR, keeping just normal short-term equity volatility in the portfolio anytime. Luckily not too many investors can unterstand it and tolerate the huge tracking error.

  3. Maybe a modified QYLD? The covered calls could be the “saver” targeting 4%+ annual with a 4% annual (buffer for expenses, etc.) it may limit upside but levers could be index, DTE, delta, long option “hedge”. I’m no expert just a thought!

    1. I do some options trading myself. It’s a good alt strategy but the standard option trading strategies like the covered call on S&P, Nasdaq or Russell 2000 have had terrible returns recently. They got whipsawed really badly. Maybe the really obvious stuff has gotten too crowded?!

      It would take a lot of skill to push up the “alpha” of those strategies to 4+%. 😉

    1. No, it’s not.
      It’s not enough to get the TR of the index. You need the FV formula plus the payment stream along the way. I am not aware of any TR swap offering this.
      What’s worse, even if there was this type of swap out there, this is not something the average retail investor would be able to access. This is normally done for large instritutional-size transactions. Which could mean that pension funds might do this kind of deal with the large players already (like Goldman Sachs or Morgan Stanlay, etc.)

  4. If the retiree/saver have a parent/child relationship, could that simplify the transactional nature through gift/inheritance laws? I wonder how common it is for this scenario to play out informally due to children supporting elderly parents whose savings ran out, but inheriting the estate if the parents have more than enough.

    1. This is a good point. The relationship also helps with the trust problem.

      At worst, the parents could say “take good care of me and I’ll increase your allocation in my will.” and have a reasonable mechanism to keep the bargain going.

    2. Well, if the savings ran out, then this is not interesting anymore. This only works if there is a sizable portfolio. Otherwise, there is no Buy-and-Hold investor equivalent.
      But you’re absolutely right: if the RSIP is between closely related people, the commitment problem of the saver becomes less of an issue. I like that idea!

    1. This entire analysis is academic… in the worse sense… in the sense that it’s a worthless tautological analysis. It’s just math applied to a situation devoid of reality.

    2. I’m not. There are many differences with a pension fund, including the fact that a retiree will forfeit all assets after they die.
      Likewise, if you are a saver in a PF and you leave the firm you can leave with a ;ump-sum but you’ll not earn stock-like returns on the contributions.

  5. My first thought upon reading this was that you were describing Social Security, and I expected the conclusion to be that we should triple the size of SS so that we can all be immune from SORR.

    In any case, this post has really helped me understand the benefit of inter-generational transfers like SS and the far more generous pension plans most industrialized democracies have. Having at least *part* of your income stream immune from SORR solves a lot of problems for retirees, and savers would be foolish to pass up the opportunity to participate. Therefore the system stays popular and is sustainable.

    Also, I would argue that Social Security IS essentially the same thing as being invested. We pay taxes in today’s dollars and get our benefits in the future based on a COLA. That is the same result as if we had invested our funds in iBonds or TIPS. It’s a 0% real return but a positive nominal return equal to the average inflation rate. More importantly, Social Security is never going to get wiped out due to a negative series of market returns. That’s the whole point about having a social contract around an RSIP rather than just taking our chances in yet another way.

    For a long time I thought it was a decent idea to invest some of the proceeds from Social Security taxes in risky investments like stocks or corporate bonds, but this article helped me realize that would utterly defeat the purpose. My personal portfolio’s SWR is higher than it would otherwise be because I can count on SS.

    1. Social Security is absolutely the opposite. Why? Because social security has no assets under the retiree’s name, no investment portfolio.

      Social Security takes money from workers today then pays it to retirees, without saving it in a portfolio. Money in = Money out, yes?

      Social Security is completely the opposite of a 401(K), the opposite of Singapore’s CPF, where the retiree has a basket of assets in their name, an investment portfolio.

      1. Exactly. Completely in line with my reply. Because there are no assets to invest you get really poor returns from SocSec. If I had taken my my OASDI contributions plus the employer match and had invested that money in the stock market I could have done a lot better.

        1. You could have also done better by putting your entire retirement into long put options on RBLX in January 2022, but that would involve taking on risk and exposure to SORR. The whole idea of SS instead of self-directed investing or traditional asset-holding pensions/annuities is to not have an entire generation of retirees all wiped out by a market event at the same time. The US stock market has done well in recent decades, but it’s also kind of an outlier. Would you trade your future stream of SS payments for the future returns of the Japanese, Turkish, or Egyptian stock market? How about Brazil’s or India’s? How can we be sure the US market won’t resemble their various returns in the future?

          As noted, SS is 100% reliable insurance, not an investment at risk. We don’t fret about the waste involved with our homeowner’s insurance every month our houses fail to burn down, and likewise we pay our OASDI (and at least get something in the end for having that program, as opposed to the insurance).

          Would SS be more efficient or less efficient if it had a several-trillion-dollar endowment containing 100% safe US treasuries? I would argue it’d be less efficient because either those funds would have to be taxed from productive users of capital or the money would have to be printed, potentially a devaluation of the currency. Such a SS would also be unable to keep up with inflation if it bought a bunch of low-yielding treasuries before an inflation uptick. As a percentage-based tax passed on to retirees, it always keeps up with inflation. No asset can 100% guarantee that except the relatively small TIPS market, and that market could not grow to the size of a national pension’s needs due to macroeconomic reasons.

          1. I absolutely agree. Besides the unique advantage of a 100% reliable insurance, the basic idea behind SS is to exactly balance two cash flows directly. A positive surplus cashflow from the active people with work and a negative one to the passive elders without work. This should be the most efficient approach if managed well and not misused for other purposes, as is the case over here in Germany.
            Why channel these two chashflows first through the volatile market, needing a huge and unreliable buffer? Ok, the only reason I can think of is to increase its liquidity and thus efficiency. But too many banksters at Goldman Sachs or LTCM before and the like misuse all margin and thus even reverse its effect by their insane gambles with billions.

          2. Chris, your assertions about “the entire reason behind SS” are not correct. Nor is your logic re other countries (how comfortable, e.g., would you feel about having your life savings dependent on a Venezuela or Cuban, or Russian – of unfortunately right now Ukrainian) pension.

            (IMO the reasons behind SS were and still are primarily political, even if I do think it’s a generally good thing that we have it)

            IMO both the pro and con sides of SS in these comments so far are missing the mark.

            SS is NOT guaranteed, even if the politics behind it mean it is very unlikely to go away, and imo most people will likely retain *most* of their “promised”/expected benefits (though the higher your expected benefits and the younger you are, the more likely there will be somewhat higher benefit cuts)

            SS is excellent longevity insurance, specifically because of the annual COLA adjustment.

            At current benefit levels, SS provides a decent enough mediocre return for lower-income contributors, and as ERN points out, a terrible return for higher income contributors (above the 2nd “kink”).

            The thing that’s been entirely missing from this conversation is that SS can work indefinitely with a growing economy with an ever increasing work force. Which we’ve certainly had for the entirety of SS existence up to about now, given Baby Boomer demographics. And if public policy enables real GDP growth of 2.5%+ and incorporates sensible legal immigration policies (including support for large amounts of high-skill immigrants), then I agree that SS is indeed a worthwhile, self-supporting social insurance policy.

            Without such pro-growth policies, SS is simply a Ponzi scheme that will eventually collapse.

            Medicare is a similar such Ponzi scheme, where the math is such that it is likely to collapse unless modified greatly.

            SS will need minor tweaks at most *if* we have sensible economic policy going forward. Current economic policy in 2021-2022, of course, could not be considered sensible by any reasonably intelligent person with a basic understanding of economics.

    2. Social Security has a horrible IRR. Most people will have trouble reaching an IRR of even 0% CPI adjusted.
      The problem is that the first generation of recipients got a great deal (having never contributed) but all subsequent generations get very poor returns, much less than what we’d get in the stock market.

      1. SocSec is no investment but an absolutely guarateed INSURANCE of longevity, completely independent of the market, whatsoever will happen to it. Thus, it is invaluable as it beats every private pension fund with respect to reliability and payout rates.
        Having sufficient private funds, I will not use up under normal market conditions, but considering the unknown high risks of the currently severely fragilised financial markets, which could get into the “Japanese Disease” of decades of no real returns after another 1929 class crash, I fill it up to my and my wifes limit and let it grow untouched as long as we can use income and private funds first to get them out of unlimited market risks. If a great reset happens after a super black swan event, It may vanish alltogether in the presently known form.
        You have to ask, why there is an upper limit to SocSec. The government would not limit it if it would be such a good deal for it. To the contrary, it is an unlimited liability that it takes over with all its powers. The limit is due to fairness. Thus, in our VUCA world, which could look completely alien in 20 to 30 years with the current explosion of speed of change and increasing crises, it is worth it. Furthermore, with the luck of having an ingenius mind I love my employed and diverse private occupations and will thus keep my human capital invested through them, tap dancing to work as a real life game and training camp every morning to keep running the ball like Warren Buffett says. This way plus a healthy life style I hope to max. my chances to remain independent from anything and thus happy as long as possible.
        At the same time I put my substantial financial assets in the all weather kind of investment according to Mutiny, Artemis & Co within a structure that I offer to likeminded clients, earning me some kind of passive income beyond purely financial returns.
        Maybe some more food for thought how to deal with unkown future risks in a consequently anti-fragile way according to Nassim Taleb, my risk management guru.

        1. There are other arguments, for and against SS (and I plan to make some in other comments), but it is simply untrue that SS is “an absolutely guaranteed” anything. Courts have made this very clear.

          Just because politically it is very unlikely that SS would go away, and unlikely even to have deep benefit cuts, does NOT mean that it is guaranteed.

          (I do agree that SS is excellent, inflation-protected longevity insurance, and any retiree even slightly worried about longevity would imo be wise to delay taking their SS benefits to get the max monthly benefit. But that is completely different from the idea that SS is absolutely guaranteed)

          1. Good point. My suspicion is that politicians will wait until the last minute to fix the issue with underfunded SS and then someone will get fleeced. There is certainly a lot of political risk here.

      2. Agreed, it is pretty terrible for most people however a handful of those perusing a leaner retirement with low lifetime earnings can do pretty well. I haven’t calculated the IRR but for instance, if you work at least 10 years and have a lifetime earnings of $1 million=$124k paid in SS taxes, you get over $16k/year in benefits adjusted for inflation, not too shabby.

        1. For relatively low earnings before the 2nd kink point, the IRR may not be so bad. Once you’re past the 2nd kink point, as many high-income white collar employees do you get a pretty lousy IRR.
          But I agree: for us in the FIRE community with only about 1/2 the work history we might get a half-way decent IRR. It also helps when factoring in the spousal strategies, i.e., who claims when.

  6. Professor ERN, I do believe I am performing a quasi-RSIP, albeit not to dissimilar to what TLV has asked. I have been retired 4 years but my wife who still works and is 10.5 years younger is the now the saver while I am the SoRR risktaker performing withdrawals so we can continue our lifestyle we have become accustomed to when we both worked. We have benefited nicely so far. Barring any significant long term bear market, I don’t even see the need to use her retirement accounts until the IRS forces her RMDs when she turns 72 in 20 years.

    1. Good for you! Your setup means that your assets are like a buy-and-hold investment because your wife brings in enough that you never have to touch your principal.
      Not everybody has this luxury, though. My wife and I both wanted to retire at the same time.

      1. Thank you professor for your share! My question about preffered stocks. I chosen to mixed with PFF(I-shares), PGX(Invesco),PFFD(GlobalX),PSK(SPDR) because is the biggest providers in market. And maybe added PFFA(Virtus) for small weight. All it for 50 % off deposit, another 50% deposit in cash. And your options strategy of course. Is it normal choice ? Because in some of your comments you not suggest etf preffered stocks. Maybe for no professional people who can not choose individual Preffered stocks, that good choice?

  7. Interesting Concept!
    I wonder it if might be more viable as a family generational concept. Such as 2 children contributing 20k each from age 30 or 35 for 30 years to fund their parents retirement. In a sense, optimizing the aggregate family investing strategy. Provided the “kids” could still have enough savings left over to maximize on tax deferred retirement plans, it could very well result in greater familial wealth. Thanks, M

  8. Thank you professor for your share! My question about preffered stocks. I don’t want to choose, but I need it in my portfolio. I chosen to mixed with PFF(I-shares), PGX(Invesco),PFFD(GlobalX),PSK(SPDR) because is the biggest providers in market. And maybe added PFFA(Virtus) for small weight. All it for 50 % off deposit, another 50% deposit in cash. And your options strategy of course. Is it normal choice ? Because in some of your comments you not suggest etf preffered stocks. Maybe for no professional people who can not choose individual Preffered stocks, that good choice?

      1. Thank you very much Professor! One question, if you chose to sell 1x leverage, which delta you preffered?

        1. I’d target the option revenue that I need to support my retirement budget. If I’m running things at 2.5x leverage, I’d look at put premiums 2.5x my current ones when using 1x leverage.
          I wouldn’t tie this to this to a strict delta vlaue.

    1. You could just look at some of the top holdings of those etfs to buy directly, most are financial or industrial such as:
      Broadcom, Wells Fargo, Citi, Nextera, DANAHER, etc.

  9. If I had a block of money outside of retirement funds how would I set this up for my kids to reduce their SORR…my SORR reduction is the block of money. 🙂

    If they max their 401K out how do I make this attractive for their taxable retirement savings? Can I smooth out both savings and retirement SORR for them because I have this block of cash that would normally be part of their inheritance if I don’t get clobbered by SORR myself?

    1. Well, this RSIP would work well between parents and children. At least the commitment problem is a bit easier to solve.
      The account mix (taxable vs. 401k) would be a bit of a headache, though.

      One way to implement this is to tell your kids to invest. If they get really good SoRR and you get really bad SoRR you simply reduce their inheritance.

Leave a Reply to earlyretirementnow.com Cancel reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.