Retirees and the ‘Risk Zone’
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Art by Ellen Weinstein
Sequence of returns risk—the combination of unanticipated volatile market conditions and planned withdrawals—is the danger of locking in losses when an unfortunately timed withdrawal is made from an investment portfolio that has suffered a significant recent loss in value.
Most retirement savers are unaware of the threat they face during the five to 10 years before and after they retire, says Ron Surz, president of Target Date Solutions and author of “Baby Boomer Investing in the Perilous Decade of the 2020s.” He calls this time frame the “risk zone.”
“During these uncertain times, any market decline beyond a person’s expected annual return creates sequence of returns risk,” says Jeff Cimini, senior vice president, retirement product management, Voya Financial. “Both employees nearing retirement and retirees may be negatively affected by recent events.”
However, Cimini says, proper retirement income planning can help retirees navigate what will likely be at least a few market corrections over the course of their retirement. He cites the “4% rule” as a frequently used guide for retirement spending, noting the method is often considered somewhat antiquated. The approach involves adding up all investments and withdrawing 4% of that total during the first year of retirement, while adjusting the withdrawal dollar amount in the following years to account for inflation. While by no means foolproof, this method can help blunt the impact of shorter-term market moves by preventing large withdrawals when markets fall.
Katherine Roy, chief retirement strategist at J.P. Morgan, says plan advisers should ensure investors who are about to draw on their retirement assets are aware of SOR risk. She says those who retire during a period of negative or volatile returns will only weather it if they can stay invested and keep a long-term view; the danger is when assets must be drawn.
Buckets and U-Shaped Glide Paths
Roy is an advocate for the bucket strategy, which many advisers use to make sure clients have a cash reserve of about one to three years. This is the first bucket, which is complemented by a mid-term investment bucket and a long-term bucket. Roy says the strategy can also involve de-risking prior to retirement, at around age 50, assuming a person has saved and invested successfully until then. Surz favors a U-shaped retirement glide path, which involves de-risking prior to retirement even more than target-date funds do. However, it also involves increasing risk later in retirement, vs. remaining conservatively invested.
“Your objective should be to protect your lifetime savings, because, many times, that’s all there is,” Surz says. “So, you need to start your retirement safe, you need to end your working life safe, but then as you spend down the assets, you need to get back into the game and increase your equity risk to increase the lifespan of the assets. That’s what creates a U-shaped glide path.”
Roy says J.P. Morgan has looked at the U-shaped glide path and the possibility of de-risking portfolios before retirement and then “re-risking” again in retirement by putting more into equity. She says this does produce better outcomes, but human behavior can make it hard to implement.
“To ask somebody in retirement to re-risk when they have a perceived declining risk tolerance—particularly those who had rocky beginnings to their retirement—it will be very difficult for them,” Roy says.
Reducing Risk
A research paper, “Reducing Retirement Risk With a Rising Equity Glide Path,” by Wade Pfau of the American College of Financial Services and Michael Kitces with Buckingham Wealth Partners, supports the U-shaped glide path in theory by suggesting that more aggressive investing through retirement can protect against SOR risk.
“We find that rising equity glide paths in retirement—where the portfolio starts out conservative and becomes more aggressive through the retirement time horizon—have the potential to reduce both the probability .. and the magnitude of failure for client portfolios,” Pfau and Kitces wrote. “The implications for financial planners are significant; it implies that the traditional approach of maintaining constant asset allocations in retirement to which the client is routinely rebalanced are actually far less than optimal.”