By Noelle Fox and Drew Denning
We all know what retiring in a down market means for the client portfolio - devastation. Understanding the potential impact of this risk is the first step toward helping clients prepare. Fortunately, there are retirement recovery strategies to help.
The past 18 months have tested the mettle of even the most risk-tolerant clients. For boomers approaching and entering retirement, the dramatic market decline was a game changer. According to the Spectrum Group, 61 percent of near retirees say the financial crisis has seriously impacted their long term plans.
The market volatility of 2008 exposed those nearing and in-retirement to sequence of returns risk. This is the risk of poor market performance occurring when it can hurt the most: in the years right before retirement and the first few years after retirement. Account values are large and recovery time is relatively low. The impact on the sustainability of retirement income can be devastating.
Understanding the potential impact of this risk is the first step toward helping clients be prepared as they near retirement and take action once they are in retirement. Fortunately, there are retirement recovery strategies to improve the chances of income lasting through retirement:
- Scale down retirement spending
- Delay retirement
- Secure guaranteed income
Using common assumptions, we tested these strategies using market conditions from 2008-- one of the worst periods of market returns in U.S. history--as the starting point for retirement. Our analysis found that employing one or a combination of these strategies along with careful planning and guidance can help prevent potential disaster even in extreme markets.
Back to the future
Chart 1 shows annual market returns for a mix of stocks and bonds from 1962 to 2008. Thirty years ago (1979), new retirees had the benefit of steadier market gains through the 1980s, making it relatively easy to withdraw an inflation-adjusted 4 percent each year for 30 years. Given expectations about market returns and retirement length--30 years and beyond--many financial experts agree that 4 percent may be a sustainable inflation-adjusted withdrawal rate. This relatively low volatility made planning for retirement less nerve-racking.
But what if the sequence of returns were reversed, with the positive returns of the '80s occurring at the end of retirement and the market volatility of recent years occurring at the beginning of retirement? Chart 2 illustrates a 30-year retirement period using historical rates of return--but in the opposite order from which they actually occurred. The 2008 losses are first and the late-'70s gains are last. The poor market returns are occurring just when retirement savings were peaking in value, exposing the most assets to risk. As the chart shows, the 4 percent inflation-adjusted withdrawal rate would not be sustainable. Savings would last only 14 years, falling severely short of a 30-year retirement.
Retirement recovery strategies
There is hope for recovery. Strategies like scaling down on spending, returning to work or investing some assets in an income generating product, like an income annuity, can improve the chances that savings will last through retirement. We put them to the test using the hypothetical "inverted historical" returns from 2008 to 1979, based on the annual S & P 500 Index (stocks) and 10-year government bonds (bonds) rates during those individual years. In each illustration, an annual increase of 3 percent is applied to the retirement income to help offset inflation.
Scaling down spending: In our earlier example, an investor retiring in the period from 2008 to 1979 (Chart 2) using a 4 percent withdrawal rate would fall far short of a 30-year retirement with savings lasting only 14 years. By changing from a 4 percent inflation-adjusted withdrawal rate down to 2 percent, retirement income should last a 30-year time frame with about $20,000 left for heirs or unforeseen expenses. Had the same investor reduced spending form 4 percent to 2 percent after 15 months of retirement, savings still would have lasted the entire 30-year period.
Delaying retirement: By delaying retirement for five years in our example, the retiree improves sustainability of retirement income from 14 to 23 years. The result is the same for someone who has been retired for 15 months and then returns to work for five years.
Purchase an income annuity: Assume the investor purchases an income annuity with an installment refund feature and fixed annual increases of 3 percent each year. While both features reduce the initial payment to the investor, they can help offset the key risks of premature death and inflation.
Continuing our earlier hypothetical example, had the 65-year-old investor used 50 percent of savings to purchase an income annuity at the onset of retirement, the remaining savings invested in a 50-50 stock and bond portfolio would provide income for 25 rather than 14 years. The annuity guarantees income and in this hypothetical example, extends the income payout range. When the income from the invested portion of the retirement savings eventually ends, the income annuity would continue paying monthly income for life. In this example, the annuity payment makes up 70 percent of the total income, so the decrease in income when savings run out is only 30 percent.
Consider a combination
Using just one of these retirement recovery strategies may require clients to make too big of a change. But combining one or more of the strategies can make changes easier yet still potentially effective. In our analysis, the following combinations helped increase the sustainability of retirement income.
3-3-30: Delay retirement by three years instead of five, reduce spending to 3 percent instead of 2 percent, and purchase an income annuity with 30 percent of savings rather than 50 percent. The remaining savings are invested in a portfolio of 50 percent stocks and 50 percent bonds. This strategy is the most conservative of the three presented here and will provide the highest remaining account value.
0-3-30: If delaying retirement or returning to work is not an option, the client could combine just two retirement recovery strategies. Rather than severely reducing spending from between 4 percent to 2 percent, the investor sets spending at 3 percent and uses 30 percent of retirement funds to purchase an annuity.
3-4-30: For a retiree who cannot reduce spending, this combination leaves the withdrawal rate at an inflation adjusted 4 percent. After delaying retirement for three years, an income annuity could be purchased with 30 percent of savings.
All is not lost
While no one can predict or control market volatility, our illustrations show that the risk of losing assets early in retirement can be somewhat manageable--even in extreme situations. By preparing your clients to consider strategies for reducing exposure to sequence of returns risk--keeping a flexible retirement date, reducing retirement spending expectations and incorporating guaranteed products in a retirement portfolio--it will be easier to make course adjustments if necessary. While prevention is best, it's never too late to take action.
Noelle Fox is an investment and product analyst and Drew Denning is vice president of Retirement and Investor Services at the Principal Financial Group. More about their analysis can be found in Sustaining Retirement Income Before and After Market Downturns, available at www.principal.com/research.