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.

Out-of-pocket health care costs

The difficulty with out-of-pocket health costs is that they are largely unpredictable. Obversely, that is the greatest thing about Canada’s publicly-funded health care system – that costs to your clients are predictable and for most clients, negligible. There are a couple of other characteristics of out-of-pocket health care expenses worth noting. To put them into perspective, the split between public and private funding of health care expenses in Canada has been around 70/30 for several decades, and while arguments can be made that the split might shift to a higher percentage for privately-funded costs in the future, no large shift seems imminent.

Remember that not all privately funded health costs are out-of-pocket costs for the person who consumes them, some being paid out of private health insurance. A second thing to consider is that privately-funded health care costs have been rising in the range of 3.1 to 3.3 per cent annually compared to 1.9 per cent annually for the Consumer Price Index for the past decade. The difference might not seem like much, but it can really add up during a 25-year retirement. Specifically, the $1000 of out of pocket health care expenses the client experiences in the first year of retirement becomes over $2500 in the 25th year at a 3.2 per cent compound annual growth rate.

Getting back to the unpredictability of out-of-pocket health care costs, the real question is not whether there will be some out-of-pocket costs, but how much they will be. And, the range of possibilities is really wide. A simple solution, of course, is to have insurance, but not all clients are likely to have insurance that covers all risks.

What to do? One approach is to ensure there is enough liquidity in a client’s portfolio to cover several thousand dollars of out-of-pocket health care costs if required. In addition, for those clients who do not have a great amount of liquidity available for unexpected costs, it would be ideal to have a plan as to what expenses could be cut either temporarily or permanently to cover these costs should a medical situation arise.

So, out-of-pocket health care costs remain a key risk to retirement income. There is no strong argument that the financial crisis by itself elevated this risk. Yet, this risk is becoming more elevated over time simply because of the aging of the population combined with the fact that health care costs can rise sharply in the last years of life.

The Three Risks in Perspective

What we have is three risks to retirement income that your client can put measures in place to help control. There are times when driving when you can’t avoid an accident. Putting the right measures in place, i.e. wearing a seat belt, protects you.

I believe that the recent global financial crisis and recession caused not only financial but also emotional pain. This is especially true for Canadians who were approaching or already in retirement. What Fidelity’s research showed was that overall the risks to retirement income haven’t changed. Hopefully what did evolve was Canadian investors understanding more completely the importance of greater individual risk assessment, as well as the need for a written retirement income plan that incorporates strategies to mitigate all five of the key risks to retirement income I’ve highlighted in these recent articles.

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in examining retirement in Canada today.