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With investment solutions, a more comfortable lifestyle may be maintained for those willing to invest aggressively in the hope of subsequently earning higher market returns to support a higher income rate. Should decent market returns materialize and sufficiently outpace inflation, investment solutions can be sustained indefinitely. Upside growth could also support a larger legacy and provide liquidity for unexpected expenses.

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However, the dual impact of market and longevity risk leaves an investment portfolio vulnerable to the possibility of being unable to support the desired lifestyle over the full retirement period. These are risks a retiree cannot offset easily or cheaply in an investment portfolio. Investment approaches seek to reduce market and longevity risk by having the retiree spend conservatively. Retirees spend less to avoid depleting their portfolio through a bad sequence of market returns in early retirement and because they must be prepared to live well beyond their life expectancy. The implication is clear: should the market perform reasonably well in retirement, the retiree will significantly underspend relative to their potential and leave an unintentionally large legacy.

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At the same time, longevity protection (the risk of outliving savings) is not guaranteed with investments, and assets may not be available to support a long life or legacy. A reverse legacy could result if the portfolio is so depleted that the retiree must rely on others (often adult children) for support. This is particularly important in light of the ongoing improvements in mortality. Today’s retirees will live longer and have to support longer retirements than their predecessors. For healthy individuals in their sixties, we are approaching the point where forty years must replace thirty years as a conservative planning horizon.

Retirees experience reduced risk capacity as they enter retirement. Their reduced flexibility to earn income leaves them more vulnerable to forced lifestyle reductions resulting from the whims of the market. A probability-based strategy could backfire.

For pre-retirement wealth accumulation, there has been less focus on appreciating the joint impact that longevity risk and market risk could play on a financial plan after retirement. Investment managers have tended to view risk pooling as unnecessary because the stock market can be expected to perform well over time. However, once distributions begin, any downward volatility in the early years of retirement can disproportionately hurt the sustainability of a retirement spending plan. With longevity risk, retirees do not know just how long their assets will need to last. Investment managers either remained ignorant of these risks or were otherwise comfortable allocating assets while treating these risks as distant and low-priority concerns.

Meanwhile, those favoring insurance (safety-first) believe that contractual protections are reliable and that staking your retirement income on the assumption that favorable market returns will eventually arrive is emotionally overwhelming and dangerous. The insurance side is clearly more concerned with the implications of market risk than those favoring investments, believing that even with a low probability of portfolio depletion, a retiree gets only one opportunity for a successful retirement. At the very least, they say, essential income needs should not be subject to the whims of the market. The safety-first school views investment-only solutions as undesirable because the retiree retains all the longevity and market risks, which an insurance company is in a better position to manage.

Today, the value provided by risk pooling is becoming better understood by investment managers as retirement income planning has emerged as a distinct field within financial services. This is happening as traditional sources of risk pooling, such as company pensions and Social Security, play a reduced role and retirees look for ways to transform their 401(k) savings into sustainable lifetime spending. Employers now tend to contribute to various defined-contribution pensions like 401(k)s, where the employee accepts longevity and investment risk and must make investment decisions. 401(k) plans are not pensions in the traditional sense, as they shift the risks and responsibility to employees rather than employers. In the transition from defined benefit to defined contribution, people are not getting as much access to risk pooling as they used to.

Without the relative stability provided by earnings from employment, retirees must find a way to convert their financial resources into a stream of income that will last the remainder of their lives. Wealth management has traditionally focused on accumulating assets without applying further thought to the differences that happen after retirement. To put it succinctly, retirees experience reduced capacity to bear financial market risk once they have retired. The standard of living for a retiree becomes more vulnerable to enduring permanent harm as a result of financial market downturns. It is now clear that the financial circumstances facing retirees are not the same as for pre-retirees, calling for different approaches from traditional investment advice for wealth accumulation..

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

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