It is important to understand from the very outset how
changing risks are primarily what separate 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 in seven general categories,
listed in Exhibit 1.1.
Exhibit 1.1: Retirement Risks
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 to the standard of
living. Prior to retirement, poor market returns might be counteracted with a
small increase in the savings rate, 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.
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 by increasing the importance of the
order 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 the
standard of living after retirement, necessitating greater care and vigilance
in response to portfolio volatility. Even a person with high risk tolerance
(the ability to stomach market volatility comfortably) would be constrained by
his or her risk capacity.
The traditional goal of wealth accumulation is generally to
seek the highest returns possible in order to maximize wealth, subject to 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.
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. After retiring, the
fundamental objective for investing is to sustain a living standard while
spending down assets over a finite but unknown length of time. The spending
needs that will eventually be financed by the portfolio no longer reside in the
distant future. In this new retirement calculus, views about how to balance the
trade-offs 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 time period such as a year. This simplification guides investing theory
for wealth accumulation. When spending from a portfolio, the concept of
sequence-of-returns risk (the order that market returns arrive) 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 below the average return earned by the portfolio during
As we just discussed, retirees experience heightened
vulnerability to sequence-of-returns risk when they begin spending from their
investment portfolio. Poor returns early in retirement can push the sustainable
withdrawal rate well below that which is implied by long-term average market
The financial market returns experienced near the retirement
date matter a great deal more than retirees may realize. Retiring at the
beginning of a bear market is incredibly dangerous. The average market return
over a thirty-year period could be quite generous, but if one experiences
negative returns in the early stages when spending begins, 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.
What happens in the markets during the fragile decade around the retirement
date matters a lot.
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 particular groups of
retirees. Some could experience much worse retirement outcomes than those
retiring a few years earlier or later. It is nearly impossible to see such an
instance coming, as devastation for a group of retirees is not necessarily
preceded or accompanied by devastation for the overall economy.
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.
Originally posted at https://retirementresearcher.com/changing-risks-in-retirement/