Exploring the Retirement Risk Zone

Workers who are approaching retirement may select a retirement date based on their ability to match the lifestyle they had before retirement from savings. If a down market reduces the amount they can spend by 20%, then they are faced with the prospect of either unacceptable lifestyle tradeoffs or the need to delay retirement.

Those who have met their savings goals prior to retirement may choose to lock in their good fortune by buying future income rather than exposing themselves to lifestyle risk.

Timing Can (Really) Matter

On Jan. 1, 2022, two couples have $1 million saved for retirement and a 60/40 portfolio. One couple retires on Jan. 1 and follows the 4% rule, allowing them to spend $40,000 adjusted for inflation every year for the rest of retirement. The other waits until May 20 to retire, but their portfolio has fallen to $840,000.

According to the 4% rule, the couple who waited a few months to retire after markets fell can now spend only $33,600, or 17% less, for the rest of their lives.

Of course, the couple that retired early now has even less money (and a higher probability of running out) than the couple that waited to retire. Following a fixed withdrawal rate strategy doesn't insulate you from the dangers of investment losses after retirement.

A down market during the retirement risk zone will have a much bigger impact on spending than a down market 15 years before or after retirement.

Those who retired near the beginning of the millennium or the global financial crisis faced the prospect of spending less than they'd hoped because markets in the years immediately before or after retirement didn't cooperate. The consequence of taking investment risk near retirement is that a retiree may either have to spend significantly less than they expected, or they may have to delay retirement to rebuild savings.

According to Granum Center research from the American College, Americans are most concerned about building a retirement plan that helps them understand how much they can safely spend after they retire. This is especially important in an era where pensions are disappearing and retirees must rely on savings to fund a lifestyle. Retirees can on average spend more when they allocate more of their wealth to risky assets, but with this risk comes the possibility that an unlucky sequence of returns will significantly impact how much they can safely spend.

Just how much do investment returns matter in the years around retirement? Do returns before retirement matter more than after (or vice versa)? And how much more does a down market a year before retirement matter than a down market 5 years before retirement? To answer these questions, we conduct an analysis where we estimate how much investment returns around retirement affect retirement spending.

Introducing Sequence of Returns Risk

Individuals who save the same percentage of the same salary for the same number of years can experience very different retirement outcomes based solely upon the specific sequence of investment returns experienced during their career and retirement. Actual sustainable withdrawal rates depend disproportionately on the shorter sequence of returns just before and after retirement. The "fragile decade" is a term that describes this 10-year period centered around retirement.

Though sequence-of-return risk is related to general investment risk and market volatility, it differs in an important way. Retiring at the start of a bear market is very dangerous because wealth can be depleted quite rapidly. With sequence risk for portfolio distributions, the extra shares sold to meet a spending goal when markets are down are no longer available to experience the growth of any subsequent market recovery. Therefore, market risk needs to be considered differently across the lifecycle.

Analysis

To provide some perspective on the relative importance of returns and retirement outcomes, we conduct a Monte Carlo analysis. We test a balanced portfolio that has a 50% allocation to equities and 50% allocation to bonds. The returns of equities and bonds are assumed to be 10% and 5%, respectively, with standard deviations of 20% and 6%, respectively, with a correlation of zero. The return and risk assumptions are intended to reflect generic long-term averages (although the results are relatively insensitive to return assumptions).

The initial balance (at age 45) is assumed to be $100,000, with $20,000 in annual cash inflows (i.e., savings) for 20 years (until retirement), where the withdrawal upon retirement is $50,000, which is approximately a 6% initial withdrawal rate from the median expected balance at retirement. Note, all values are in real terms and taxes are ignored.

The analysis includes 1 million different trials. For each individual trial, we estimate the number of years the portfolio can generate income in retirement, with a maximum of 50 years.

Next, we estimate the correlation between the returns for that respective year to the number of years of income generated for that entire trial. We do this for each of the 40 years in the simulation.

An important note about the analysis is that the results are relatively unaffected by portfolio risk levels, portfolio returns, the length of retirement, the initial portfolio withdrawal rate, etc. The one key assumption that does impact the relative importance of the accumulation years is the ratio of the savings amounts in accumulation versus the initial balance (because savings in effect are a form of negative alpha).

Also, while this analysis deals with individual correlations, we also perform multivariate regressions and note virtually an identical effect. In other words, the findings appear to be relatively robust across a range of specifications.

The results of the analysis show that returns immediately before retirement have the greatest impact on retirement spending, and as an individual approaches retirement, the importance increases each year. Returns immediately after are also important, but the impact of returns falls more rapidly such that the return five years after retirement matters about as much as the return 10 years before retirement.

Correlation Between Portfolio Returns and Years of Retirement Income

These results are not intended to suggest returns in retirement are not important, rather that sequence risk needs to be considered before retirement. There are other important behavioral considerations to consider as well.

Planning Implications

What does this mean for financial advisors working with retirees? It means we need to start thinking more proactively about how to manage risk before retirement. We're not suggesting near-retirees should move into no-risk portfolios; however, the downside of investment risk may be more consequential in the years immediately before and after retirement than may advisors and retirees fully appreciate. Therefore, considering an asset allocation or protection strategy may be more valuable for near retirees who want to avoid the possibility of having to make a substantial lifestyle change.

David Blanchett is head of retirement research at Prudential and a portfolio manager at PGIM. Michael Finke is a professor of wealth management for The American College of Financial Services and its Frank M. Engle Distinguished Chair in Economic Security. Wade Pfau is a co-creator of the Retirement Income Style Awareness tool and the director of retirement research at McLean Asset Management. Pfau is a professor of practice at the American College of Financial Services and Blanchett is an adjunct faculty member.