Just as the skill set for climbing a mountain differs from descending it, accumulating assets is very different from generating retirement income. In accumulation, your participants seek to maximize risk-adjusted returns to build wealth. Generating income, however, requires growing assets to maintain spending goals over an unknown time horizon. We contend this new challenge – balancing longevity and market risks – will change the trade-off preference between upside potential and downside protection.
“…this new challenge – balancing longevity and market risks – will change the trade-off preference between upside potential and downside protection.”
Funding a Retirement that’s Longer than a Career
A long life expectancy is a good thing, but you must consider the stream of income required to fund it. Many of us may outlive our life expectancy, which may lengthen with future breakthroughs in healthcare and improvements in socio-economic conditions, diets, and exercise.
You can see these risks more clearly using the Actuaries Longevity Illustrator (ALI) to estimate longevity. We used it to show the probability of living to a specific age for Jack and Jill, a hypothetical 65-year-old married couple who are non-smokers and in average health condition (Figure 1).
The chart illustrates both individual and couple longevity, which is helpful for setting realistic planning horizons. For example, if Jack and Jill are willing to accept an 11% chance that one of them will outlive their assets, then they will want to generate income until age 100. That’s a 35-year planning horizon!
Income Projection Wake-up Call
By linking assets to future income, a lifetime income projection reveals to your participants the challenge of sustaining a portfolio for 35 years. Returning to our hypothetical couple, assume Jack has a $1 million balance in his DC plan, and he receives a lifetime annual income projection of $31,918 (i.e., 3.2% spending rate).1
This income estimate assumes purchasing a joint and 100% survivor annuity with a 3.0% cost-of-living adjustment, which essentially eliminates longevity risk. It’s a 3.5% internal rate of return that offers great peace of mind; however, Jack and Jill require $45,000 in annual withdrawals adjusted for inflation for 35 years to maintain their lifestyle (i.e., 4.5% spending rate). Alternatively, they could use a low-risk, diversified portfolio that keeps up with a 3.0% inflation assumption, but that would fall short. To fund their 35-year spending goal they would need to boost the balance by over a half million dollars or take more risk to achieve a 5.7% annualized return.
The decision to use an annuity or a diversified portfolio is not an either-or proposition. Your participants have a spectrum of lifestyle choices and risk preferences. But when you consider potential reductions in DB benefits and the solvency of government pensions, we observe many of DC plan participants may need to accept some market risk to reduce their income shortfall (Figure 2), unless their choices expand.
Diversified portfolios not only offer the potential for closing funding gaps, but unlike a standard annuity, they also provide liquidity for unexpected spending shocks (e.g., healthcare), the opportunity for higher lifetime spending and the possibility of leaving a legacy.
Market Risk Can Be Devastating
Relying on a diversified portfolio is familiar ground for participants, having spent most of their careers invested in capital markets; unfortunately, investment volatility can also shorten portfolio life and increase longevity risk. In accumulation, dollar-cost-averaging mitigates the effects of volatility; however, when making portfolio withdrawals, the higher the volatility, the faster a portfolio depletes.
Re-visiting Bengen’s (1994) “4% Rule” for safe, systematic withdrawals, Pfau (2019) examined the worst 30-year sequence of U.S. capital market returns to study the impact of increasing and reducing portfolio volatility on retirement wealth (1966-1995). As you might expect, he found that changes in volatility had a significant effect on portfolio life (Figure 3).
“…changes in volatility had a significant
effect on portfolio life.”
He calculated the terminal values of a hypothetical $1 million equity portfolio with inflation-adjusted systematic withdrawals for five different levels of volatility while holding the annual arithmetic returns the same. If you reduced volatility 10%, you increased your remaining wealth by $1.6 million after 30 years. A 20% reduction in volatility increased wealth by $3.2 million over the same period. Conversely, increases in volatility shortened portfolio life considerably.
A greater reliance on a diversified portfolio also increases exposure to market drawdowns, which are quite large and frequent, historically. Figure 4 illustrates the magnitude and frequency of global equity drawdowns by calendar year over 50 years using month-end returns. The average maximum drawdown in a calendar year was -10.3%. Every year but one experienced a drawdown, and nearly 40% of them were more than -10%.
The mathematical effect of drawdowns on cumulative outcomes is well known. A portfolio with a negative return of 10% requires a subsequent positive return of 11.1% to break even; a negative return of 20% requires a 25% positive return. But for in-retirement investors, the timing of these drawdowns is critical because withdrawals effectively lock-in losses and accelerate portfolio depletion.
Known as sequence-of-returns risk, drawdowns just before or after retirement can dramatically shorten the life of a portfolio and reset sustainable withdrawal rates. Your participants’ sustainable withdrawal rate will vary based on their near- and post-retirement return sequence (Figure 5).
Descending the Mountain
Retirement income investors will need new solutions to address the balance between longevity risk and market risk. Contact us to discuss why these risks are moving to the forefront for DC plan participants and the solutions that attempt to solve this challenge.
1While waiting for U.S. Department of Labor guidance, we created a lifetime income projection by averaging all immediate annuity quotes from blueprintincome.com (accessed on August 6, 2020) using $1,000,000 of qualified assets for a joint and 100% survivor annuity. This is a hypothetical example only.
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