How much our world has changed.
In 1950, a retiring 65-year-old male worker’s average life expectancy was 12.8 years. While this mortality average translated into 50 percent of retirees living past age 78, it also assumed the other half would die in their 60s or 70s.
That was then. Demographers now project that by 2050, 1 in 4 Americans will be 65 or older, 20 million people will live beyond age 85 and 1 million will live past age 100, effectively producing the Florida-zation of America.
Wanting to exploit this escalating demographic, virtually anyone who sells or distributes retail financial services is now eager to label themselves (overtly or covertly) as retirement planners. The predictable result is a boomer demographic overwhelmed by industry and media noise and left confused (and anxious) about their retirement future.
Adding to the confusion are growing concerns about the 4 percent rule, long a retirement gold standard. In 1994, research by William Bengen, a CFP and author, revealed what a safe retirement withdrawal percentage should (theoretically) be when adjusted for inflation annually. This prominent thesis determined that 4 percent of a portfolio’s value (comprised of 50 percent stocks and 50 percent bonds) could be safely withdrawn from the initial portfolio, and then annually adjusted for inflation for 30 years.
But in 2008, Nobel laureate William Sharpe (of Sharpe Ratio fame) released research that found the 4 percent rule wasn’t always successful. Rather, he cited historical success rates somewhere between 85 percent and 90 percent (i.e., a failure rate of 10 to 15 percent). While Sharpe’s safety disclosure didn’t do much to dampen the retirement planning industry’s overall enthusiasm for Bengen’s 4 percent rule, it did place a cynical chink in the armor, causing some academics to begin to question the validity of this standard bearer.
Their main concern is with the risk known as sequence of returns. This risk involves the actual order in which a retirement portfolio’s investment returns occur. Generally, negative portfolio returns early in retirement have a more destructive impact on the retiree’s income portfolio than negative returns in the later part of retirement. This early drag on the portfolio’s value is caused by both negative market performance and withdrawals necessary to fund retirement needs. The result is a smaller portfolio. A smaller portfolio contains fewer assets, and is therefore unable to capitalize as effectively on future rebounds, threatening the affordability of day-to-day living expenses.
Careful examination suggests there are at least four additional risks (some involving sequence of returns) for a retirement planner to overcome when addressing the challenge of developing a sustainable inflation-adjusted retirement income portfolio. Collectively, these risks are known as four inflation-adjusted retirement income risks, or FIARIR (pronounced “fire”).
See also: 7 important retirement equations
1) Equity sequence of returns
Equity sequence of returns has been discussed earlier. However, it should be noted that retirement planners are often tempted to exclusively denote equities as all or some portion of the stock market. When broadly discussing equities in regard to an inflation-adjusted retirement income portfolio, any type of real asset ownership can be classified as an equity (e.g., real estate, REITs, oil and gas, collectibles), not simply publicly/privately traded stocks.
2) Bond-yield sequence of returns
Michael Finke, Wade Pfau and Morningstar researcher David Blanchett addressed the risk of bond-yield sequence of returns (although not by name, or even through segregation) in their essay, “The 4% Rule Is Not Safe in a Low-Yield World.”
Finke, Pfau and Blanchett (using Bengen’s portfolio model of 50 percent stocks and 50 percent bonds, a 4 percent inflation-adjusted withdrawal rate, average current real — after-inflation — TIPS’ return as well as the historic real equity premium) concluded that a current retiree withdrawing an inflation-adjusted 4 percent would have a 57 percent chance of portfolio failure. Portfolio failure was defined as the retirement account running entirely out of money.
The 57 percent portfolio failure rate assumed that bond-yields will not revert to their historical real averages of 2.6 percent. But because of bond-yield sequence of return risk, research shows that a future climb in real interest rates is not as promising as one might suspect. If real bond returns center on -1.4 percent for 10 years and then revert to the historical (real) 2.6 percent average, the failure rate drops from 57 percent to 32 percent. Even if the interest rate reversion happens in five years, the failure rate is still 18 percent.
3) Sequence of inflation
When discussing FIARIR (or even the general category of sequence of returns) there seems to be an absence of conversation about the sequence of inflation. This is puzzling, as the historic rate of inflation over the past 40 years has averaged nearly 4.5 percent. (This 40-year time frame is significant because actuaries are currently projecting that at least one spouse will live 40 or more years in 10 percent of retirement cases.)
What about the future? Is there agreement among economists that the United States is destined for high inflation in the foreseeable future? Some say no; some say yes; and others differ. However, because of the recent and continued high velocity of money creation and since the sequence of inflation is a proven FIARIR risk, 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.
Often, baby boomers and retirees underestimate their longevity by guesstimating their life expectancy, based upon some blood relative’s age at death or assuming one’s own demise to be governed by average life expectancies at birth. While there is a minor correlation among family members’ longevity, life expectancy of dead relatives is not a factor on which one’s own retirement duration (and consequently, one’s income needs) should be based.
It leads to the obvious consequence for many retirees (as well as ill-informed retirement planners) of an underestimation of realistic life expectancies in retirement (and a corresponding retirement income deficit).