Improving the Outlook for a Successful Retirement: A Case for Using Downside Hedging

Abstract

One of the biggest risks to a successful retirement is the exposure of savings to poor investment returns in the early stages of the retirement. Mitigating this “sequence-of-returns” risk is in consequence an important investment question. In this study, we conduct extensive simulation analysis to show that for sustainable withdrawal rates, hedging with costless collars or with put options can eliminate or significantly reduce funding shortfall risk for a retirement portfolio. In addition, we demonstrate with a few examples that, for a given level of shortfall risk, hedging can increase the income generated by retirement savings by almost 40%. Thus, downside hedging strategies within retirement portfolios appear to offer attractive benefits to retirees worried about outliving their income resources.