Will You Outlive Your Income?
The prospect of living longer, healthier lives should be exciting for everyone, especially those who wish to spend more time with their children and grandchildren. However, many retirees are approaching extended longevity with some trepidation, wondering if their hard-earned assets will be sufficient to fulfill their vision of a happy and carefree retirement. At the critical point when assets need to be converted to income, retirees need assurance that they won't outlive their nest eggs, which, to some, would be a fate worse than death.
Old Rules of Thumb Have Become Dangerous Assumptions
Unfortunately, the traditional retirement planning models espoused by the media and general financial services industry are outdated, and only serve to generate more angst among retirees. Not only do many models still follow the "allocate for your age" strategy, their spending assumptions are based on the traditional life expectancy model that requires us to die "on time" in order for the plan to be successful. In today's low interest rate environment and in the face of longer life expectancies, these planning models seem blissfully ignorant to current reality.
Indeed, there was a time when stock market returns and bond yields worked symbiotically to generate stable returns for retirement portfolios. During this period of time, the "allocate for your age" model provided retirement savers with a reasonable sound and simple formula of asset allocation that, when adjusted for age, would automatically reduce volatility while still producing sustainable income and growth. For those unfamiliar with this strategy, a 40 year-old investor would allocate approximately 40% of his portfolio to bonds and 60% to stocks. Similarly, a 60 year-old investor would allocate 60% of his portfolio to bonds and 40% to stocks. So on and so forth.
While stocks and bonds generated steady returns throughout the 1990s and 2000s, retirees could comfortably withdraw up to 4% of their portfolio value annually without worrying about depleting their investment assets at an inopportune moment. Of course, in addition to the tailwind of stable returns, retirees were also expected to live much shorter lives. Since the early 2000s, though, we have seen bond yields continue to fall and stock market volatility at an all-time high. As a result, investors and financial advisors were forced to adjust the "allocate for your age" strategy not by changing the allocation, but by reducing the withdrawal rate. Instead of withdrawing the standard 4%, retirees were advised to draw 3% or less.
The Inherent Risks of Investing Too Conservatively
In today's increasingly complex market environment, the biggest mistake investors make is being too conservative. An extensive study by Fidelity Investments offers clear evident that portfolios highly-weighted in "traditionally safe" investments are likely to exhaust their assets well before they reach current life expectancy. The study shows that a portfolio invested in 100% short-term fixed-income vehicles will be exhausted within 25 years. Conversely, portfolios which have a 20% allocation to stocks will last an additional 5 years, and a 50/50 stock/bond portfolio will last indefinitely at a withdrawal rate of 4-5% annually.
Although these statistics are theoretical and may not apply equally to everyone, the illustration is clear. Increasing one's exposure to equities, especially as part of a retirement income plan, may seem counterintuitive. While there is an increased element of risk, investors are far more likely to experience decreased asset value and reduced purchasing power due to inflation and longevity risk by investing too conservatively. Research has shown that a deliberate exposure to risk, when applied prudently and carefully, will help to consistently generate above-average returns and mitigate the risk that a portfolio will be depleted too soon. It is through the management of risk, not the management of investments, that optimum stability can be achieved. And, of course, stability is the critical objective for any retiree.
A Different Perspective: Safe Savings Rates
The field of retirement research is certainly not shrinking. New concepts, ideas, and strategies are being presented every day. Wade Pfau, a thought leader in the industry, has suggested an alternative to safe withdrawal rates, called the "Safe Savings Rate." In his paper on the subject, titled Safe Savings Rates: A New Approach to Retirement Planning over the Lifecycle, Pfau suggests starting to save for retirement early, and beginning with the end in mind. Rather than accumulate assets for 30-40 years and then determine how much income can be withdrawn annually, one should imagine how much income one will need once retirement has been achieved, and calculate the average annual savings required to reach that target income. Although this approach requires a great deal of assumption (average rates of return, expected number of years employed, estimated Social Security benefits to be received), it does present an interesting alternative to the traditional withdrawal model we commonly see.