Retirement income planning has changed drastically over the last three decades. Thirty years ago most Americans could safely rely on Social Security and a pension to provide the income they needed in retirement. That’s no longer the case. Today we have much greater personal responsibility to create our own retirement income plan. To help make sure that a retirement portfolio lasts a lifetime, we will have to prepare for and manage the following common risks to retirement income.
Market trends are one of the most important factors to portfolio longevity, perhaps second only to the retirement account’s withdrawal rate. Investors typically spend decades saving for retirement. Systematic investing in a fluctuating market coupled with historically rising trends has helped many Americans accumulate sizeable retirement accounts. However, when Americans retire and stop contributing to and start withdrawing from retirement accounts, they become much more susceptible to market risks.
Chances are most retirees will have to live through at least one bear market. In fact, the average retiree will likely face three to five such bear markets in retirement. Since 1945 there have been 27 market corrections of greater than 10 percent and 12 bear markets with losses that exceed 20 percent. The average bear market lasts 14 months with an average loss of 33 percent. Assuming no withdrawals are taken from their retirement savings, it will take an investor 25 months to recoup those losses.1
Sequence of returns risk
Taking withdrawals during a bear market will accelerate the depletion of retirement savings, adversely affecting a portfolio’s ability to provide lifetime income. During the accumulation phase of retirement planning, the sequence of returns doesn’t much matter. The average rate of return is what’s important. However, during the income phase of retirement, the sequence of returns matters greatly. Beginning your retirement in a time of positive market performance increases the chances that retirement savings will last a lifetime. However, negative market returns in the early years of retirement will likely require the retiree to liquidate more investments to provide the income they need. This, of course, will increase the likelihood of depleting their retirement savings sooner. Unfortunately, no one can predict whether they will be retiring into a rising, flat or a negative sequence of market performance.
Interest rate risk
Most agree that the interest rates today are low. This creates additional pressure for the average retiree to create the income they need to live comfortably in retirement. In the past, many could rely on an interest of 5 percent or more. In fact, the 10-year U.S. Treasury note was above 5 percent from 1968 until 2002 and was over 7 percent from 1975 to 1993.2 With interest rates at those levels, obtaining a decent return on their retirement dollars was as simple as going to the bank and purchasing a CD. However, with the 10-year treasury hovering around 2 percent, retirees may be forced to withdraw more from their retirement savings to make up the shortfall caused by low interest rates or invest more aggressively in search of greater yields.
Investment behavior risk
Investor behavior has a profound impact on portfolio performance. Investors are often influenced by their emotions. These emotions, which can include fear, excitement, greed, euphoria or panic, can disrupt a long-term investment strategy. We also have an aversion to loss that could affect our ability to stay in the market. Investors will often get in and out of the market at the wrong time. This is evidenced by the fact that net inflows to equity funds tend to rise with stock prices and net outflows tend to occur when stock prices fall. From 1996 through 2015, the S&P 500 Index gained an average of 8.19 percent while the average investor earned only 2.11 percent. In order to benefit from any potential long-term market appreciation, the investor should consider remaining invested through difficult times.3
Inflation risk is purchasing power risk. It’s the chance that investment income will not be worth as much in the future. Inflation is typically measured by the Consumer Price Index (CPI) produced by the United States Department of Labor. The CPI program compiles monthly data on prices consumers paid for a representative basket of goods and services. Since 1981, prices of these goods and services have increased annually by 2.8 percent. The Department of Labor also produces a consumer price index for the elderly called CPI-E. The prices paid by the elderly for goods and services have increased by 3.1 percent since 1981. The reason inflation tends to be higher for retirees is due in large part to health care costs which have increased annually by 5 percent since 1981. Inflation creates an increased demand on income and is most damaging in later years of retirement.4
Longevity risk is the risk that you will outlive your money. When creating a strategy for transitioning savings to retirement income, the issue of longevity must be addressed. A 65-year-old married couple has nearly a 50-percent chance that one member will live to age 92 and 25-percent chance to age 97. Of course the challenge is how to generate income that will last 30 years or more.5
Withdrawal rate risk
Retirees should be mindful of how much they withdraw from their accounts each year. A safe and sustainable withdrawal rate is defined as how much can be taken from a portfolio with little probability of depleting the account. The success of these withdrawal rates are dependent on several factors including age of the client, length of retirement, asset allocation, market conditions and interest rates at the time. A 4-percent withdrawal rate, first made popular by William Bengen, was long viewed as safe and sustainable. In light of people living longer in retirement and a prolonged low interest rate environment, new research is suggesting a sustainable withdrawal rate closer to 3 percent to 3.5 percent.6
Creating income security and ensuring a successful and happy retirement is no easy task. Many Americans have been saving and preparing for retirement their entire working life. As they begin to transition into the longest vacation of their life, they should make sure that their retirement income plan is structured to withstand these seven common risks.
1 Bloomberg Financial, January 2016.
2 U.S. Department of Treasury.
3 Dalbar, Inc. Indexes 1996 through 2015.
4 U.S. Department of Labor.
5 U.S. Annuity 2000 Mortality Table, Society of Actuaries.
6 Morningstar. Investment News, 7/2015.
The Prudential Insurance Company of America, Newark, NJ.