This article is a part of a series; click here to read Part One.
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
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.
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.
Originally posted at https://retirementresearcher.com/overview-of-retirement-income-planning-part-two/