Why Retirement Investing is Different
When you switch from your accumulating years to your distribution years (retirement), a lot of things change. You’re no longer going to work, you’ve got time to explore your interests, and the world is your oyster. A lot of things change about investing when you’re retired as well. In this paper we’ll outline the five biggest risks you face investing in retirement and offer a few solutions for how to invest after retirement.
Sequence of Returns Risk
Sequence of returns risk, or sequence risk, is a situation wherein the timing of your withdrawals can have a negative effect on your retirement, affecting your total assets you have to retire on and the amount of time they’ll last.
Sequence risk is most pronounced in the five years before and after you retire, which are known as the “fragile decade.” This is because the market returns you realize during this decade disproportionately affect the success of your retirement. In fact, one study by Retirement Researcher found that over a 30 year retirement period, the first ten years explain 80% of the eventual retirement outcome.
Even if you have the same average rate of return over time, the sequence in which you experience that return can have a significant impact on your retirement. The example below illustrates this point. Let’s say you start with $1 million and you’re withdrawing $50,000 per year (with a 3% increase) and your portfolio has an average return of 5%. The blue line in the graph below illustrates this simple model.
However, life isn’t so simple. Let’s say that the average return is still 5%, but let’s say the annual returns are cycling as 15%, 7%, 3%, and -5% (the orange line). Conversely, let’s keep the same average return and individual annual returns, but instead let’s experience them in reverse order: -5%, 3%, 7%, and 15% (the gray line). As you can see, the model with the worst sequence risk (gray line) runs out of money before the model with no sequence risk (blue line), and that one runs out several years before the model with a virtuous sequence (orange line). In fact, the orange line model lasts approximately five years, or 22% longer, than the gray line, and all that changed was the order in which the returns are realized.
So how do you minimize sequence of returns risk? For starters, make sure you have a comprehensive financial plan, which will consider all eventualities, including the possibility of prolonged exposure to sequence risk. Additionally, the main fallout from sequence risk is the chance of having to liquidate assets in a down market to pay for essentials. One solution to avoiding this is our HCM Dividend GrowthTM plan. By investing in dividend-paying stocks, when the market is low you can receive cash for owning the stocks and still maintain ownership, rather than being forced to liquidate when the market is down, creating a negative disproportionate impact.
Additionally, you can do whatever is in your power to rely as little on your investments as possible during your “fragile decade.” One possible suggestion for people at the beginning of their fragile decade is to decide on a post-retirement spending budget, and over a six-month period restrict yourself to that spending level. During that period, keep track of what pushes you over budget, and what you need to change in order to maintain your budget. Additionally, take stock of what you aren’t yet spending money on, like healthcare currently covered by a workplace plan, and figure out what new costs will need to be accounted for. Also, you could hold money as cash or bonds, which are typically much more stable than stocks, to cover short-term expenses.
Longevity risk is your risk of outliving your retirement portfolio’s ability to support yourself. This could result in a lower standard of living, reduced care, or a return to employment. Advances in medicine and technology have had an impact on aging within our society. However, nobody wants the success of their retirement plan to be contingent on an early death.
Key drivers of the growing need to address longevity risk include an aging population, increasing life expectancy, uncertainty of government benefits, and economic volatility.
By 2030, all baby boomers will be older than age 65. This will expand the size of the older population so that 1 in every 5 residents will be retirement age. As the population ages, the ratio of older adults to working-age adults, also known as the old-age dependency ratio, is projected to rise. By 2020, there will be about three-and-a-half working-age adults for every retirement-age person. By 2060, that ratio will fall to just two-and-a-half working-age adults for every retirement-age person.
The average lifespan has been increasing for several decades and has no signs of slowing down. According to the Census Bureau, the U.S. average life expectancy at birth increased 62% from 47.3 years in 1902 to 76.8 in 2000, with expectations it will reach 79.5 in 2020. As such, the conservative approach of planning for 30 years in retirement may no longer be enough, and it definitely won’t be enough in the future.
How do you address longevity risk? Since the largest exposure to costs that most people have are health costs and long-term care, do what you can to stay as healthy as possible: eat right, exercise regularly, get enough sleep, etc. In the financial markets, there are a number of ways to address longevity risk. After that, it all comes down to planning. At HCM Wealth Advisors, we know the threat of longevity risk is real, and we account for it in every financial plan we produce. We consider actuarial science, add in a factor of safety, and plan to that updated level. One way to do that is by delaying when you claim social security. By claiming at age 70 instead of age 62, your income could increase by as much as 76%. This requires some sacrifice early on, but it’s like having “Longevity Insurance” in your later years.
Interest Rate Risk
Although interest rate risk does affect stocks, albeit indirectly, it primarily affects bonds. Interest rate risk is the risk that interest rates may change unexpectedly, causing the value of fixed-income securities, primarily bonds, to suffer as a result.
For some background: as interest rates rise, bond prices fall, and vice versa. This happens for two reasons. Generally speaking, as interest rates increase, the opportunity cost of holding money increases, and the return from the bond decreases as a result. More specifically, bonds have a fixed coupon rate. If interest rates rise above this fixed level, investors can take advantage of that new interest level by investing in new products that reflect the new interest rate. In order to sell the old security, it has to have a lower selling price than the new securities.
To offer an example: an investor buys a 5-year bond for $1,000 and a 3% coupon. If interest rates rise to 4%, the investor is going to have a hard time selling the original bond when there are new bonds in the market with more attractive rates. Additionally, low demand may precipitate lower prices on the secondary market, possibly causing the investor to earn less than they paid for it previously.
An implication of this is that longer-term bonds suffer more from interest rate risk than shorter-term bonds. The reason for this is that, when interest rates rise, a short-term bond will mature soon, allowing the investor to reinvest in a new security that takes advantage of the new interest rate. On the other hand, a long-term investor is stuck in the longer-term investment for many more years, causing them to experience greater price sensitivity.
One thing a good financial planner will do to avert interest rate risk is diversify bond holdings. By holding a variety of bonds with many different maturation schedules, the possibility of being significantly harmed by a rise in interest rates is substantially limited. Other possibilities include an investor buying interest rate futures, selling long-term bonds, or buying floating-rate or high-yield bonds.
Inflation risk is the risk that the rate at which prices increase over time will decrease your purchasing power in retirement. The typical measure of inflation, the Urban Consumer Price Index, includes such goods as food, clothing, housing, medical care, energy, etc. A 3% increase in prices may not sound like much today, but over time and through compounding, it can manifest as a real danger to your ability to live a secure retirement.
During your accumulation years, as inflation rose, typically wages rose as well to compensate for inflation. In your distribution years, when you’re living off of assets or a fixed income, you no longer have the benefit of a wage increase to address inflation. Its impact can be substantial to your portfolio. Over time, inflation averages out to being somewhere between 2% and 3%, but it has swung as high as 6.1% in 1990, 12.5% in 1980, and 18.1% in 1946. Over a 25-year retirement, 2% inflation represents a $113,000 decrease in purchasing power, while 3% inflation represents $184,000 in decreased purchasing power. Moreover, costs that retirees tend to spend money on, such as health care, usually rise faster than inflation. Since 1938, health care costs have risen faster than inflation 82% of all months, in one month rising almost 20% faster. Overall, health care has increased 44% faster than inflation since 1938.
As you can see, inflation is a very real and consistent threat. It must be accounted for when planning a retirement portfolio. Most research suggests that a retiree can withdraw 4% of their portfolio sustainably; when factoring in typical inflation, the return must be closer to 6% or 7%.
One thing you can do to address this is reduce your housing costs. Stepping down into a condo or smaller house or apartment can help you reduce monthly costs such as mortgage payments, property taxes, homeowner’s insurance and maintenance. Also, delaying taking Social Security can be a big help. Social Security payments increase over time with what is known as a cost-of-living increase. The longer you delay taking social security, the more Social Security income you’ll receive, meaning a greater part of your income will have inflation protection included in it. Long-term care insurance usually offers inflation protection as well, but buying too much inflation protection will be a needless strain on your income, decreasing your quality of life and retirement security.
So, what can a financial advisor do for you to address inflation risk? Diversification is key. Too much money in fixed income products, such as bonds, will cause you to lose money when inflation is high. For example, if your bond has a yield of 3.5%, and inflation is at 4%, your bond is now generating a negative yield. Stocks aren’t necessarily the answer, though. On one hand, inflation is high when the economy is good, so companies will likely be doing more business, causing share prices to increase. On the other hand, this also means that their cost of raw materials will also increase, which could cause shares to decline. Experience and knowledge of which stocks to select is a service your financial advisor can offer. Some of these products may include Real Estate Investment Trusts or utility stocks.
A financial advisor will also have experience planning for long-term care and will be able to advise you on what sort of inflation protection is ideal given your unique situation.
Additionally, this is another situation in which our Dividend Growth PortfolioTM is a lifesaver. The dividend-paying stocks we select rise in value while paying a regular income. The income from these dividends we choose increases over time, typically exceeding inflation. This offers you a dependable, in-cash income, growing faster than inflation, making your retirement more secure.
Withdrawal Rate Risk
One of the most difficult challenges that retirees face is determining what their withdrawal rate from their portfolio should be. Withdraw too much, and you risk running out of money before you die. Withdraw too little, and you may miss out on the many experiences life has to offer in your post-retirement life.
The most famous rule-of-thumb for safe withdrawal rates is what’s known as the 4% rule, discovered and popularized by William Bengen. According to this rule, you should be able to withdraw 4% of your portfolio on year 1, then adjust for inflation in the following years, and live comfortably for 30 years in retirement. For example, if you have $1,000,000 in assets, your first year’s withdrawal would be $40,000 ($1,000,000 * 4%), then you would account for inflation in later years. Assuming 2.5% inflation, your next year’s withdrawal would be $41,000, then $42,025, and so on.
A few notes: the 4% rule doesn’t account for taxes. It also has fairly specific asset allocations that are required to maintain the 4% withdrawal rate.
But this isn’t the only rule in town. Another approach to safe withdrawal rates says that you can withdraw up 7% per year, given a set of favorable market conditions. Others say that the correct rate is somewhere between 2% and 3%, maintaining that the 4% rule makes overly favorable assumptions about bond returns. Others say that you should never touch the principal of your investments, and as such your withdrawal rate should never exceed the 10-year government bond yield or the S&P 500 dividend rule.
Of course, retirement isn’t a one-size-fits-all kind of thing. It should be customized to every individual based on factors they can control (when you choose to retire, your investments, whether you plan to leave money to heirs) and things you can’t control (how long you live, interest rates, inflation, and long-term behavior of the market). As such, there’s no one hard-and-fast rule about how to set your withdrawal rate. Instead, what your advisor should implement is a dynamic process where your individual situation and aspirations are considered, along with the current and future trends of the markets and come up with a withdrawal strategy that makes sense for you. After this, the advisor should continue to closely monitor the situation, noting any factors that may have changed and adjusting the withdrawal rate as needed.
Ultimately, none of these risks occur in a vacuum; they are all simultaneously present throughout your retirement. Sequence risk will have a significant bearing on your withdrawal rate, which is informed by the interest rate and inflation, which is constantly at interplay with your longevity risk. In order to ensure these risks are handled appropriately, reach out to a financial advisor to see how they manage risks and return to provide you a secure retirement.