Two Major Risk Factors to Retirement Success
For most people its not until they hit 50 do they have the O.S. moment – do I have enough money for retirement? Am I on track to continue my lifestyle when I stop working?
There are many principles we focus on early and often in financial life management, but a couple very few address are a couple risk factors that are largely out of your control but you must prepare for – Sequence of Return Risk and Longevity Risk. Traditional financial planning just can’t address these two issues so they largely are ignored, however, they are critical to what your “retirement’ lifestyle will be if you don’t address them now.
#1 - Sequence of Return Risk is the order in which you get returns on your portfolio, i.e. 5% year one, 12% year two, 8% year three, -9% year four, etc. It’s not just the real return which matters, but also the order of these returns. Getting negative returns at the start of retirement can have a devastating impact on your retirement and how long you can live without running out of money. A 20% drop could wipe out 30 years of gains! You never know when the down market will appear and its effects on your portfolio.
The sequence of returns leading up to and into retirement make a huge impact on the amount of income you will have. Suppose you have a $500,000 retirement fund and need to know how much you can withdraw to live on for the next 20 years. The stock market has averaged 10.24% annual return from 1926-2014. So you would think you should be able to pull at least 10% per year, on average, and have your money last 20 years. On $500,000 that gives you $50,000 annual income. Even if the return fluctuates in the future, as long as it averages at least 10 percent per year, the fund should last 20 years, right?
Wrong! Given typical levels of stock market volatility there are only slim odds that the fund will survive the full time. The following charts simulate this retirement strategy with actual S&P 500 returns starting in various years from 1992 – 1995.
*Figures from Guardian Life Variable Interest Rate Calculator. Uses actual S&P 500 annual returns over 20 years with 3% annual inflation increase.
As Ed Easterling puts it in Unexpected Returns, “The cycles that occur during an individual’s period of investment will dramatically influence the returns that investor realizes.” For investors to ignore the strategic implications of this investing reality is folly.
Even with the same behavior and doing everything “right,” you can get very different results even with the same average return. This is sequence of returns risk!
#2 - Longevity Risk – The risk that you will live a long life and outlast your money. In retirement, longevity risk becomes the greatest risk because the longer retirement lasts (the longer you live) the greater the chance you will succumb to other forms of risk. Increased longevity means more time for another financial crisis, increased chances for health problems, housing costs, more time for inflation to compound, and so on.
Running out of money is usually at the top of the list of concerns when building a retirement income plan. And, it should be!
Once you get into retirement you no longer have an income. Your income is determined by your assets. Retirees often require regular withdrawals from their portfolio to pay for living expenses. Traditional methodology is that you spend the interest off your assets (hope that is enough!) or a combination of interest and the assets themselves.
To ensure your money will last your advisor says to invest more conservatively to lessen your chances of losing money. But at the same time you are diminishing your returns, which means a greater likelihood of dipping into your principal. Neither is a prospect for success!
Maintaining some acceptable level of return means a portion of your portfolio is at higher risk. High portfolio volatility increases the likelihood that you will have to withdraw funds while the portfolio is down, maybe even deep down. The amount of remaining principal determines the amount you can safely withdraw each year. High portfolio volatility and suffering a large loss requires a reduction in retirement income (and lower standard of living). This matters a lot because now you’ve begun a downward spiral from which you may never be able to recover. Sharp drawdowns and roller-coaster volatility can drive you to sell equity holdings to cover living expenses. As a result, you get to experience the decline but not the recovery, which will quickly erode the portfolio and leave you without any income.
Diversification is traditional portfolio theory’s answer to managing these risks. While diversification may manage non-systematic risk (specific risk), it fails to manage systematic risk (market risk, day-to-day fluctuations in the market), particularly during bear markets. Asset allocation, as we’ve noted above, only gets you so far. Many markets that were once normally non-correlated now move together under economic stress. Diversification can then fall short when it is needed the most.
So what’s the answer? We’ve studied this A LOT and have come up with some unique answers that are easy to understand and simple to implement.
Download our free guide to learn how we avoid these major risks to your retirement and start living the life YOU want:
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