4 retirement income risks — and how to avoid them

How much our world has changed.

In 1950, a retiring 65-year-old male worker’s average life expectancy was 12.8 years. While this mortality average translated into 50 percent of retirees living past age 78, it also assumed the other half would die in their 60s or 70s.

That was then. Demographers now project that by 2050, 1 in 4 Americans will be 65 or older, 20 million people will live beyond age 85 and 1 million will live past age 100, effectively producing the Florida-zation of America.

Wanting to exploit this escalating demographic, virtually anyone who sells or distributes retail financial services is now eager to label themselves (overtly or covertly) as retirement planners. The predictable result is a boomer demographic overwhelmed by industry and media noise and left confused (and anxious) about their retirement future.

Adding to the confusion are growing concerns about the 4 percent rule, long a retirement gold standard. In 1994, research by William Bengen, a CFP and author, revealed what a safe retirement withdrawal percentage should (theoretically) be when adjusted for inflation annually. This prominent thesis determined that 4 percent of a portfolio’s value (comprised of 50 percent stocks and 50 percent bonds) could be safely withdrawn from the initial portfolio, and then annually adjusted for inflation for 30 years.

But in 2008, Nobel laureate William Sharpe (of Sharpe Ratio fame) released research that found the 4 percent rule wasn’t always successful. Rather, he cited historical success rates somewhere between 85 percent and 90 percent (i.e., a failure rate of 10 to 15 percent). While Sharpe’s safety disclosure didn’t do much to dampen the retirement planning industry’s overall enthusiasm for Bengen’s 4 percent rule, it did place a cynical chink in the armor, causing some academics to begin to question the validity of this standard bearer.

Their main concern is with the risk known as sequence of returns. This risk involves the actual order in which a retirement portfolio’s investment returns occur. Generally, negative portfolio returns early in retirement have a more destructive impact on the retiree’s income portfolio than negative returns in the later part of retirement. This early drag on the portfolio’s value is caused by both negative market performance and withdrawals necessary to fund retirement needs. The result is a smaller portfolio. A smaller portfolio contains fewer assets, and is therefore unable to capitalize as effectively on future rebounds, threatening the affordability of day-to-day living expenses.

Careful examination suggests there are at least four additional risks (some involving sequence of returns) for a retirement planner to overcome when addressing the challenge of developing a sustainable inflation-adjusted retirement income portfolio. Collectively, these risks are known as four inflation-adjusted retirement income risks, or FIARIR (pronounced “fire”).

See also: 7 important retirement equations

1) Equity sequence of returns

Equity sequence of returns has been discussed earlier. However, it should be noted that retirement planners are often tempted to exclusively denote equities as all or some portion of the stock market. When broadly discussing equities in regard to an inflation-adjusted retirement income portfolio, any type of real asset ownership can be classified as an equity (e.g., real estate, REITs, oil and gas, collectibles), not simply publicly/privately traded stocks.

2) Bond-yield sequence of returns

Michael Finke, Wade Pfau and Morningstar researcher David Blanchett addressed the risk of bond-yield sequence of returns (although not by name, or even through segregation) in their essay, “The 4% Rule Is Not Safe in a Low-Yield World.”

Finke, Pfau and Blanchett (using Bengen’s portfolio model of 50 percent stocks and 50 percent bonds, a 4 percent inflation-adjusted withdrawal rate, average current real — after-inflation — TIPS’ return as well as the historic real equity premium) concluded that a current retiree withdrawing an inflation-adjusted 4 percent would have a 57 percent chance of portfolio failure. Portfolio failure was defined as the retirement account running entirely out of money.

See also: Advisors disagree on retirement planning approaches

The 57 percent portfolio failure rate assumed that bond-yields will not revert to their historical real averages of 2.6 percent. But because of bond-yield sequence of return risk, research shows that a future climb in real interest rates is not as promising as one might suspect. If real bond returns center on -1.4 percent for 10 years and then revert to the historical (real) 2.6 percent average, the failure rate drops from 57 percent to 32 percent. Even if the interest rate reversion happens in five years, the failure rate is still 18 percent.

3) Sequence of inflation

When discussing FIARIR (or even the general category of sequence of returns) there seems to be an absence of conversation about the sequence of inflation. This is puzzling, as the historic rate of inflation over the past 40 years has averaged nearly 4.5 percent. (This 40-year time frame is significant because actuaries are currently projecting that at least one spouse will live 40 or more years in 10 percent of retirement cases.)

What about the future? Is there agreement among economists that the United States is destined for high inflation in the foreseeable future? Some say no; some say yes; and others differ. However, because of the recent and continued high velocity of money creation and since the sequence of inflation is a proven FIARIR risk, every retirement income plan should incorporate investment vehicles that will counteract the effects of our current moderate inflationary environment and the very real possibility of more aggressive inflation in the future.

4) Longevity

Often, baby boomers and retirees underestimate their longevity by guesstimating their life expectancy, based upon some blood relative’s age at death or assuming one’s own demise to be governed by average life expectancies at birth. While there is a minor correlation among family members’ longevity, life expectancy of dead relatives is not a factor on which one’s own retirement duration (and consequently, one’s income needs) should be based.

It leads to the obvious consequence for many retirees (as well as ill-informed retirement planners) of an underestimation of realistic life expectancies in retirement (and a corresponding retirement income deficit).

How to prevent a FIARIR

One may partially or fully mitigate the risks of a retirement income portfolio against the FIARIR by using an investment vehicle that is not subject to equity or bond-yield sequence of returns, sequence of inflation or longevity.

Pfau has constructed several inflation-adjusted retirement income comparatives illustrating varying percentages in stocks and bonds; differing percentages of stocks with a variable annuity invested 70 percent in stocks and 30 percent in bonds (with a guaranteed lifetime withdrawal benefit, or GLWB); and a differing percentage in stocks and a regular single-premium indexed annuity, or SPIA.

The stock/SPIA product allocations proved (by no small margin) to produce the most efficient frontier when matched against either a stock/bond or stock/VA comparative. In other words, replacing bonds with a SPIA solved three of the four inflation-adjusted retirement income risks: the risks of equity sequence of returns, bond-yield sequence of returns and longevity risk. The only FIARIR the SPIA does not resolve is the sequence of inflation risk.

SPIAs work particularly well when substituted for bonds in an inflation-adjusted retirement income portfolio. Unfortunately, more than a few retirees, as well as retirement planners, struggle with placing lifetime SPIAs inside a retiree’s income portfolio. The challenges with which they sometimes struggle include:

- A general aversion to annuities

- The finality of the decision

- No residual for heirs

- Lack of control

- Lack of diversification

A more flexible SPIA

While overweighting a retiree’s income portfolio with SPIAs and SPIA-like income may be problematic, avoiding the SPIA solution may not be in the retiree’s best interest either. SPIAs, while underwritten by bonds, prove to be better bonds in respect to retirement income because of their ability to pool risk. Risk pooling is combining the uncertainty of individuals into a calculable risk of large groups.

With the onslaught of the baby boomers and the expected corresponding demand for investment control, a new generation of risk-pooled income evolved. These were generically called fixed indexed annuities (FIAs) with an income rider.

Current competitive state-of-the-art fixed income annuities can give the retiree emergency access to remaining principal up to 20 years after triggering income, link the retiree’s income to inflation (CPI) for up to 30 years and allow for income streams to be turned off and on. They are also uncapped and, most importantly, continue to be risk-pooled. In obtaining this flexibility, when compared with the SPIA, the retiree often gives up a little initial guaranteed income potential, but gains the possibility of higher market-linked retirement income, especially for those who experience longevity in retirement.

If the retirees’ major concern is with ensuring sustainable joint income for life, rather than maximizing the husband and wife’s ultimate inheritance value, then the stock/real FIA outperforms the stock/SPIA at all of the asset allocation percentages in our assumed 3 percent inflation scenario by a substantial margin.

While the SPIA is immune to three of the four major inflation-adjusted retirement income risks (as previously mentioned), the reason the real FIA’s income (divorced from the stock allocations) performs so well is that it also eliminates the fourth major risk, sequence of inflation. For every year there is inflation, the real FIA will increase its income payout, whereas the SPIA payment will remain constant.

 

For more on retirement planning, see:

The New Year's resolution every advisor should make

4 ways insurance can protect your clients’ retirement funds

401(k) market projected to grow 9% in '14

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