If you think you know the risks to retirement income, guess again. You could be basing your recommendations to clients on stale research and traditional inflation-adjusted models that could fail your clients. Test yourself:
Which of the following are risks to retirement income?
A. Equity sequence of returns
B. Bond-yield sequence of returns
C. Sequence of inflation
E. All of the above
The correct answer is E. All of these are risks, according to a new analysis by Wade Pfau, a professor of retirement income in the new PhD Program for Financial and Retirement Planning at The American College, and Rex Voegtlin, a Certified Financial Planner with 30 years of experience. In their white paper, “Mitigating the Four Major Risks of Sustainable Inflation-Adjusted Retirement Income,” they assert that there are additional risks that advisors could be exposing their clients to when using the traditional 4-percent rule. The “sequence of returns” risk, or the order in which a retirement portfolio’s investment returns occur, remains the widely accepted major risk because retirement planners generally still use William Bengen’s 1994 inflation-adjusted income study. His study established the “the 4-percent rule” — that retirees can safely withdraw 4 percent of a portfolio’s value (comprised of 50 percent stocks and 50 percent bonds) each year and then annually adjust for inflation for 30 years. This inflation-adjusted model no longer works, as people are living longer than the projected 30 years in retirement, Pfau and Voegtlin argue. In addition to the risks of longevity and sequence of returns, they identify two others. They dissect Bengen’s sequence of returns risk into two — equity sequence of returns and bond-yield sequence of returns — and assert that these risks also should be examined when developing a sustainable inflation-adjusted retirement income portfolio.
You can download the white paper for a more-detailed explanation of each risk, but here’s a summary:
Equity Sequence of Returns
Generally, negative portfolio returns early in retirement have a more destructive impact on a retiree’s income portfolio than negative returns in the later part of retirement. Pfau and Voegtlin model this scenario and also one in which the losses are reversed and primarily experienced at the end of the retirement period. In the first scenario, assuming a 4-percent withdrawal rate (growing at an assumed 3 percent per year), the retirement portfolio would run out of money in 15 years. In the second scenario, the portfolio runs out of money and ends with 50 percent of the original invested proceeds. Clearly, equity sequence of returns is a major risk.
Bond-Yield Sequence of Returns
Bond yields today are unusually low. Current intermediate-term real bond-yields (adjusted for inflation) are 4-percent lower than their historical norm. Just as sequence of equity returns can negatively impact the portfolio, so can the sequence of bond returns. The white paper uses Pfau’s and others’ research to conclude that a current retiree withdrawing an inflation-adjusted 4 percent would have a 57 percent chance of a retirement account running out of money. Even if bond yields return to the historical average at different times, the research still showed a portfolio failure rate of 18 percent. And none of those models factored in management fees.
“For a retirement planner to place retirees in an inflation-adjusted portfolio allocation that has at best an 18-percent chance of portfolio failure (over a 30-year retirement scenario) seems, at the very least, questionable,” they write.
Sequence of Inflation
Of course we know inflation matters, but did you know that sequence of inflation matters? Consider Pfau and Voegtlin’s case study showing two portfolios that experience the same returns, same withdrawal rate, same average inflation, but one fails in 15 years and the other lasts for 36. The only difference is the sequence of inflation is reversed. Their conclusion: 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.
Pfau and Voegtlin assert that U.S. lifetime mortality tables are misleading and that the most relevant mortality statistic is not one’s life expectancy at birth, but rather one’s life expectancy during retirement. Their calculations determine that nearly one-third of married couples retiring today will have longer mortality than Bengen’s 30-year retirement model.
Translation: retirement planners using the traditional 4-percent rule, based off traditional life-expectancy tables, set portfolios up for failure.
How to Mitigate Clients’ Portfolios Against These Risks
So now you know the risks. How do you help clients mitigate retirement income portfolios against them?
Pfau constructed several inflation-adjusted retirement income comparatives. The BalancedChoice Annuity (BCA) with the BALIR 30-year inflation-adjusted income rider outperformed other product allocations at a 4-percent assumed inflation rate. To learn more, download the white paper.