Key risks to retirement income – Part 2

I think we can all agree that when it comes to retirement income planning it is better to be safe than sorry and it’s important to plan for the unknown as much as possible. It is the same reasoning most of us use when we get into our cars and do up our seat belts. In last month’s column, I focused on the two key risks to retirement income that your clients can’t control. This month, I am going to explore the three key risks that – with your help – they can manage.

If you missed my previous column, Fidelity Investments first wrote about the five key risks to retirement income in 2005. The risks, as we saw them were longevity, inflation, asset-allocation, withdrawal rates and out-of-pocket health costs. But, a lot had happened since our paper was first published – not the least of which being the global financial crisis, the subsequent recession, the recovery and the ongoing market volatility.

We thought it important to revisit the five key risks in light of what has happened in recent years to ensure that the risks remained relevant. You can find our updated report, ‘After the global financial crisis – the 5 key risks to retirement income’ on our website.

Last month we concluded that both longevity and inflation remain risks and that in fact, especially when it comes to inflation, may be more elevated than before the crisis began. So what does our “revisit” reveal about the risks around asset-allocation, withdrawal rate and out-of-pocket health care costs?

Asset Allocation

The central question around asset allocation is not whether it is important to your clients’ success – it is – but how they choose to treat it. Few would deny that short-term or tactical changes to asset allocation can be valid. Fidelity’s portfolio managers regularly make such adjustments in response to opportunities different markets present. Strategic or longer-term changes are another matter. I would argue that any properly constructed asset allocation should be done initially based the client’s fundamental characteristics — risk tolerance and time to retirement being among the most important. Generally, changes to a portfolio’s strategic asset allocation should consider only changes to strategic variables such as the client’s age or their employment situation or their investment goals.

When properly utilized, asset allocation assists your clients in dealing with risk, market volatility and liquidity. Many investors understand the importance of all three, which is why most portfolios have some equities, fixed-income and cash. Prior to the global financial crisis there was, at least for some investors, a sense that risk was almost non-existent or perhaps not worthy paying attention to. Those investors who believed that the risk was small had, in some cases, portfolios whose asset allocation didn’t properly reflect their goals or situation. That perception quickly changed when the crisis hit. During the crisis, asset allocation did change for many investors as they sought the safety of cash investments. The end result for some is a far too conservative portfolio for investors who require growth to achieve their retirement income goals.

This suggests that asset allocation remains a key risk to retirement income. And, it suggests that this risk is elevated relative to before the financial crisis in so far as some clients may have over-reacted to the crisis and surrounding events such that their portfolios do not represent the goals they are trying to achieve.

Withdrawal rates

Of all the five key risks, withdrawal rates experienced the most stress as the result of the global financial crisis and its aftermath. The problem is simple but the solution, unfortunately, is not. Fidelity’s research shows that anything more than a four or five percent annual withdrawal rate from a portfolio’s original value, adjusted annually for inflation, increases the risk of an investor outliving their money. Clients who increased their withdrawal rate during the crisis to compensate for a declining portfolio value (and therefore a decreasing monthly withdrawal amount) now face additional difficulty, especially if they adjusted their portfolios to a more conservative asset allocation. Their nest egg was greatly reduced and they have not participated in the market’s recovery from the stock market lows.

The big question is how should clients approach this situation? There are a couple of possibilities. One would be to save and invest enough that a four per cent withdrawal rate early in retirement would, based on the projected size of their portfolio, provide more than enough income. If the portfolio did drop in value just before retirement, the client could stick to the four per cent withdrawal rate and still cover expenses.

The second approach is to ‘tough it out’ in the early retirement years when keeping the annual withdrawal rate down is the most crucial. ‘Toughing it out’ it likely means reducing expenditures from previously-planned levels early in retirement or obtaining some employment income to supplement income from the lower-valued portfolio. As the client moves through retirement, their planning horizon shortens and they can re-evaluate their annual withdrawal rate.

All of this leaves withdrawal rates as a continuing risk to retirement income. And, even though the Chicago Board Options Exchange Market Volatility Index (VIX) doesn’t presently show it, with the sense of market volatility that many of us feel today, we conclude that the risk to retirement income posed by withdrawal rates is elevated compared with the pre-crisis situation.