The Changing Risks of Retirement
Originally published at Forbes
The changing risks of retirement are the primary differentiator of retirement income planning from traditional wealth management. Retirees have less capacity for risk as they become more vulnerable to a reduced standard of living when risks manifest. Those entering retirement are crossing the threshold into an entirely foreign way of living. These risks can be summarized into seven general categories, listed in the following figure.
Reduced Earnings Capacity
Retirees face reduced flexibility to earn income in the labor markets as a way to cushion their standard of living from the impact of poor market returns. One important distinction in retirement is that people often experience large reductions in their risk capacity as the value of their human capital declines. As a result, they are left with fewer options for responding to poor portfolio returns.
Risk capacity is the ability to endure a decline in portfolio value without experiencing a substantial decline in your standard of living. Prior to retirement, poor market returns might be counteracted with a small increase in the savings rate, or possibly by a brief retirement delay, or even a slight increase in risk taking. Once retired, however, people can find it hard to return to the labor force and are more likely to live on fixed budgets.
Visible Spending Constraint
At one time, investments were a place for saving and accumulation, but retirees must try to create an income stream from their existing assets — an important constraint on their investment decisions. Taking distributions amplifies investment risks (market volatility, interest rate volatility, and credit risk) by increasing the importance of the ordering of investment returns in retirement.
It can be difficult to reduce spending in response to a poor market environment. Portfolio losses could have a more significant impact on standard of living after retirement, necessitating greater care and vigilance in response to portfolio volatility. Even a person with high risk tolerance, which is the ability to stomach market volatility comfortably, will be constrained by their risk capacity.
The traditional goal of wealth accumulation is generally to seek the highest returns possible in order to maximize wealth, subject to your risk tolerance. Taking on more risk before retirement can be justified because many people have greater risk capacity at that time, and can focus more on their risk tolerance. However, the investing problem fundamentally changes in retirement.
After retiring, the fundamental objective for investing is to sustain a living standard while spending down assets over an unknown, but finite, length of time. Furthermore, the spending needs that will eventually be financed by the portfolio still reside in the distant future. Investing during retirement is a rather different matter from investing for retirement, as retirees worry less about maximizing risk-adjusted returns and worry more about ensuring that their assets can support their spending goals for the remainder of their lives. In this new retirement calculus, views about how to balance the tradeoffs between upside potential and downside protection can change. Retirees might find that the risks associated with seeking return premiums on risky assets loom larger than before, and they might be prepared to sacrifice more potential upside growth to protect against the downside risks of being unable to meet spending objectives.
The requirement to sustain an income from a portfolio is a new constraint on investing that is not considered by basic wealth maximization approaches such as portfolio diversification and Modern Portfolio Theory (MPT). In MPT, cash flows are ignored and the investment horizon is limited to a single, very lengthy, period. It is a simplification that guides investing theory for wealth accumulation. When spending from a portfolio, the concept of sequence of returns risk becomes more relevant, as portfolio losses early in retirement will increase the percentage of remaining assets withdrawn to sustain an income. This can dig a hole from which it becomes increasingly difficult to escape, as portfolio returns must exceed the growing withdrawal percentage to prevent further portfolio depletion. Even if markets subsequently recover, the retirement portfolio cannot enjoy a full recovery. The sustainable withdrawal rate from a retirement portfolio can fall well below the average return earned by the portfolio during retirement.
Heightened Investment Risk
As a quick summary of what we’ve just covered, retirees experience heightened vulnerability to sequence of returns risk once they are spending from their investment portfolio. Poor returns early in retirement can push the sustainable withdrawal rate well below what is implied by long-term average market returns.
The financial market returns experienced near your retirement date matter a great deal more than you may realize. Retiring at the start of a bear market is incredibly dangerous. The average market return over a 30-year period could be quite generous, but if negative returns are experienced in the early stages when you have started spending from your portfolio, withdrawals can deplete wealth rapidly, leaving a much smaller remainder to benefit from any subsequent market recovery, even with the same average returns over a long period of time.
The dynamics of sequence risk suggest that a prolonged recessionary environment early in retirement without an accompanying economic catastrophe could jeopardize the retirement prospects for a particular group of retirees. Particular retiree groups could experience much worse retirement outcomes than those retiring a few years earlier or later, and devastation for a group of retirees is not necessarily preceded or accompanied by devastation for the overall economy.
The fundamental risk for retirement comes in the form of unknown longevity. The length of your retirement could be much shorter—or longer—than the statistical life expectancy. A long life is wonderful, but it is also costlier and a bigger drain on resources. How long will a retirement plan need to generate income? Half of the population will outlive their statistical life expectancy, and some will live much longer. For many retirees, the fear of outliving resources may exceed the fear of death.
Unexpected expenses could relate to any number of matters, including an unforeseen need to help other family members, divorce, changes in tax laws or other public policy, changing housing needs, home repairs, rising health care and prescription costs, and the need for long-term care. Retirees must preserve flexibility and liquidity to manage unplanned expenses. When attempting to budget over a long retirement period, it is important to include allowances for such contingencies.
Retirees face the risk that inflation will erode the purchasing power of their savings as they progress through retirement. Low inflation may not be noticeable in the short term, but it can have a big impact over a lengthy retirement, leaving retirees vulnerable. Even with just three percent average annual inflation, the purchasing power of a dollar will fall by more than half after twenty-five years, doubling the cost of living.
Sequence of returns risk is amplified by greater portfolio volatility, but at the same time many retirees cannot afford to play it too safe. Short-term fixed income securities might struggle to provide returns that exceed inflation, causing these assets to be quite risky in a different sense: they may not be able to support a retiree’s long-term spending goals. The low-volatility assets are generally viewed as less risky, but this may not be the case when the objective is to sustain spending over a long time horizon. Over long periods, even low levels of inflation can create dramatic impacts on purchasing power. Retirees must keep an eye on the long-term cumulative impacts of even low inflation and position their assets accordingly.
Declining Cognitive Abilities
Finally, a retirement income plan must incorporate the unfortunate reality that many retirees will experience declining cognitive abilities, hampering portfolio management and other financial decision-making skills. For the afflicted, it will become increasingly difficult to make sound portfolio investments and withdrawal decisions in advanced ages.
In addition, many households do not equally share the management of personal finances. When the spouse who manages the finances dies first, the surviving spouse can run into serious problems without a clear plan in place. The surviving spouse can be left vulnerable to financial predators and make other financial mistakes. Survivors often become more exposed to fraud and theft.
While liquidity and flexibility are important, retirees should also prepare for the reality that cognitive decline will hamper the portfolio management skills of many as they age, increasing the desirability of having an advanced plan locked into place.