Picture this: two boomers, each of whom starts with the same amount of money in the bank at age 62. But at the ripe old age of 91, one is bereft of savings while the other is sitting on nearly three-quarters of a million dollars–even though each individual has drawn down savings at the same rate and enjoyed the same average return.
Though counterintuitive, the contrasting outcomes highlight the importance of boomers’ investment choices and the impact those choices have on retirement. David Odenath, president of Prudential Annuities, a unit of Prudential Financial, Newark, N.J., cited the example during an audio Webcast as key to understanding the results of a new Prudential study released last month, “Are You Ready for the Retirement Red Zone?”
“The red zone is a critical time that will determine whether someone will have enough money to save for retirement,” said Odenath. “Our new study suggests that conventional wisdom may leave retirees short.”
That conventional wisdom, he added, predated new developments in technology and medicine that are prolonging retirees’ lives beyond traditional life expectancy. Concurrently, companies increasingly are transitioning from defined benefit plans to defined contribution plans, thereby transferring the responsibility of funding retirement from the employer to employees.
Odenath identified the “retirement red zone”–the five years before and after retirement–as a particularly important window for boomers to strengthen their retirement savings and to protect against the financial risks associated with unpredictable events, such as inflation, health problems or a decline in the stock market.
While all investors face these risks, the ability of those in the red zone to recover or adjust is generally more limited. One reason: Pre- and post-retirement boomers have to keep their investments growing while simultaneously drawing (or preparing to draw) retirement income. How they invest, and when they receive high and low returns on those investments, can make all the difference between a comfortable and bare-bones retirement income.
To illustrate, Odenath described two red zone scenarios: each of two individuals who start with $250,000 in retirement savings at age 62 but who achieve substantially different outcomes three decades hence. This happens despite the fact that each investor enjoyed the same average return (7%) over the 30-year period and drew down savings at 5% annually.
The first individual suffered several years of negative returns, followed by mostly positive returns from ages 69 through 91. The second individual secured identical returns but in reverse order: high early returns initially, followed by negative returns during the final years of retirement. Upshot: The first individual depleted his retirement assets by age 79, whereas the second ended with $712,574.
Sixty-three percent of Prudential’s 1,000 U.S. survey respondents said they were not aware of how dangerous early stock market declines in the retirement red zone can be to retirement security. This figure included 36% who were aware of the risk but surprised by the magnitude of the impact to their savings–plus another 27% who said they had never considered the problem. Women, the report noted, were more likely than men to be oblivious of the risk.
“This [example] magnifies the importance of the red zone,” said Odenath. “It’s really the sequence of returns that matters.”
Using a second illustration, Odenath pointed up the difficulty that a hypothetical American, who starting with a $308,000 investment, would face in achieving a $350,000 nest egg after experiencing investment declines of 19% and 15%, respectively, during the third and second years prior to retirement. In the last year of employment, the individual, now with $212,000 invested, would need a 45% return to close a $138,000 shortfall.
Just more than one-third of the survey respondents (36%) believed that they could make up for the loss within five years. About two-thirds expected they would need more than five years or that they would never be able to recover the loss.
If faced with this situation, four in 10 respondents said they would postpone retirement or return to work. A third (34%) indicated they would scale back their lifestyle to compensate for the loss. The remaining 25% would rely on a market rebound–which may or may not happen in a timely fashion.
“The prevailing theory [about investing] is that, as you get closer to the retirement date, you should become more conservative in your asset allocation,” said Odenath, adding the examples cited challenge the theory. “Awareness of the retirement red zone caused [respondents] to think about managing their investment risk, rather than avoiding it.”
To best manage that risk, Odenath counseled that boomers participate in their employer-sponsored retirement plans up to the maximum limit; use appropriate asset allocations strategies; and seek the advice of a financial professional. To manage catastrophic risks, they should also consider purchasing supplementary life and/or long term care insurance.
Odenath said that boomers additionally can mitigate investment risk by purchasing variable annuities offering guaranteed minimum withdrawal, income and accumulation benefits. So, for example, if an investor’s account is depleted due to withdrawals and adverse market performance, using a guaranteed income benefit, the individual still can enjoy a guaranteed income for the rest of his or her life.
“You get the guaranteed lifetime income without the perceived loss of control of the assets,” said Odenath. “These [annuity] riders have become very popular just in the last two years.”