Building A Secure Retirement
There are many ways to approach the question of how to prepare financially for a secure retirement.
Here’s a simple approach:
1. Save as much money as possible.
2. Maintain a flexible budget in retirement so you can withdraw less when markets are ugly.
3. Have a component of income guaranteed with some sort of annuity for longevity insurance.
Wouldn’t all that be a neat trick? But here are a few reasons why it’s not so simple:
“As much money as possible” might not be much money
People get sick, lose their jobs, and face other unexpected hardships
Living on a flexible budget in retirement is easier said than done
Markets go down a lot at times, and sometimes they stay down for long periods
On the positive side, people also inherit money, sell their houses for multiples of what they paid, and otherwise experience good fortune
Sometimes life is short, and you’ll wish you had spent more money enjoying yourself
But life can also be very long, and you could have large expenses at the end
Social Insurance and defined benefit pension plans were designed to address some of the above challenges on behalf of workers. The objective of Social Insurance is to alleviate old-age poverty and provide a minimum level of inflation-adjusted income in retirement. But it is not meant to maintain the standard of living to which many had while working.
Defined benefit plans were usually created to give workers a portion of their preretirement income throughout retirement. But defined contribution pension plans have become the much more common type of employer-sponsored plan. Whereas defined benefit plans are designed to guaranteed income for retirees, defined contribution plans are designed to help workers accumulate wealth but not with an income guarantee.
The decline of defined benefit plans has transferred much of the responsibility of retirement planning to the worker. This is also true post retirement because defined contribution plan portfolio management and advice often ends at retirement. This is limiting because the retirement-planning challenge does not end at the point of retirement.
Common questions I hear:
How much income am I likely to need in retirement?
What percentage of my income should I save, considering my current savings and how long I expect to work?
What is the significance of my employer’s contribution to my retirement income?
What is the effect of retiring earlier or later than expected?
Is the Target Date Fund strategy the most appropriate?
Should my asset allocation change over time as retirement approaches?
Should I favor an indexing or active approach to investing?
Should I consider insurance products such as annuities? If yes, when should they be purchased and what annuity features should I incorporate or avoid?
Should reverse mortgages be part of my toolbox?
How should I react to or prepare for another severe market downturn? What are my options? Is the answer the same whether I am 10 years from retirement or 5 years post retirement?
How do I protect myself against longevity risk? What if I live to be 100 years old?
What frequency of monitoring is required, and in what circumstances should I adjust my retirement plan?
What are the most common behavioral pitfalls, and what features of a plan can protect me from my own fears and reactions?
The answers to the above questions would be easier if only we had a bit more certainty in life… Without all that uncertainty, retirement planning would be easy.
But we can simplify a little bit. In principle, these are the important variables:
1. How long you save
2. How much you save
3. What investment return you earn
4. When you retire
5. Your desired retirement income
6. How long you live
Even if we have some control over when to start saving, our ability to save substantially for retirement is influenced by many considerations, such as the purchase of a home, the cost of raising children, and unexpected career developments. We have even less control over investment return patterns, although we do have control over how we invest.
Although unrealistic, presenting and analyzing simple scenarios in which all the parameters are known helps to conceptualize retirement planning challenges. This allows you to isolate the relevant retirement parameters and assess their significance.
Then you can start to look at the potential financial effect of each source of uncertainty and how the uncertainty can be addressed.
Meet John.
John is 30 years old, single, and without savings. He will retire at age 65 and will live until he is 85. John earns $60,000 per year, and his income will increase annually in line with inflation of 2%. John will save 10% of his gross income monthly. Once retired, he will receive a monthly retirement payout, inflation adjusted yearly, that will drain all his wealth by the time he is 85.
John’s annualized return on investment is 5.4% over this 55-year span. He pays no advisory or investment management fees.
Under the proposed scenario, John’s salary starts at $60,000, and by the time he retires, his salary will have risen to $117,641. Assuming a savings rate of 10% and an annualized return of 5.4%, he will have accumulated $775,096 by age 65.
Assuming again that the return remains at 5.4% and that John lives to age 85, he will be able to afford an initial annual retirement income of $53,412. This income will rise by 2% per year and is enough to maintain about 45% of the inflation-adjusted income John was earning before retirement.
What this example illustrates
This example demonstrates that a sustained saving effort and a high return rate are required to achieve a modest retirement income even when there is zero uncertainty.
This analysis raises important questions. What happens if John starts saving later, earns a lower investment return, retires earlier or later, or lives longer? This scenario will serve as our reference benchmark.
Impact of a Lower Investment Return
Assume the return is 4.2% instead of 5.4%. The effect of lower returns is significant. Reducing the return from 5.4% to 4.2% reduces wealth as of retirement by 20.6%, from $775,096 to $615,511. The level of John’s wealth attributed to his savings alone has not changed ($299,967).
Assuming John intends to maintain the same ratio of retirement income to his pre-retirement income as in the base scenario (45%), he will be able to sustain this level of income only until age 79. At that age, he will have fully exhausted his wealth. If John’s objective is to maintain a retirement income until age 85, the annual income will have to be reduced.
Impact of Procrastination
Let’s assume John starts saving at age 40 instead of 30. If we assume that John intends to maintain the same ratio of retirement income to pre-retirement income as in the base scenario, how long can that ratio be fully maintained?
Starting to save ten years later would make it impossible to pay the full retirement income beyond age 75 if John starts saving at age 40. Or, the longer John waits, the greater the effect on the required savings rate. Waiting 10 years requires him to increase the savings rate by 69%, from 10% to 17%.
Impact of Retiring Later or Sooner
Assuming John retires at age 63, his retirement income declines from 45% to 38% of his pre-retirement income, which translates into a 15% reduction in income.
In comparison, postponing retirement to age 67 increases the ratio to 53%, an 19% rise in income.
Changing the retirement age can substantially affect a retiree’s financial well-being. It may be a last-resort option when total wealth has not reached the expected level.
Impact of Longevity
Longevity is a significant issue and a concern when planning for retirement. Under the base scenario, if John were to live beyond age 85, he would have no more income.
Assuming John wants his portfolio to sustain a retirement income up to age 95, the ratio of retirement income to pre-retirement income would have to decline from 45% to 34%, an income reduction of 24%.
Impact of Making All the Wrong Choices
What if John makes all the wrong choices? He doesn’t start saving until age 40, achieves lower investment returns than expected, has to retire at age 63, and underestimates his longevity, living to age 95. Assume his savings rate remains at 10%.
In this case, John’s ratio of retirement income would be an inadequate 15% of pre-retirement income, or 72% less than assumed under the base scenario. He generates significantly less in investment income because of the reduced number of years invested. Likely John would be unable to retire at age 63.
What you control and what you do not
Several investment-specific factors significantly affect your financial situation as you accumulate wealth pre-retirement:
1. Average level of real returns (returns net of inflation) during the accumulation period
2. Pattern of returns (their volatility and sequence);
3. Investment policy, specifically how aggressive or conservative your asset allocation
You have no control over the level of real return that financial markets deliver during your lifetime. Nor do you control the pattern of returns during the accumulation and decumulation periods. You do control your asset allocation though.
A product to manage risk and fear
Recently, target date funds (TDFs) have become a popular retirement investment product. These funds are designed to provide investors with well-diversified portfolios with risk profiles that decrease automatically over time as investors approach their ‘target date’ retirement.
The asset allocation’s evolution over time is often called a glide path. Most glide paths are similar in structure. They apply a high equity allocation until approximately 20 years from retirement, then go through a transition period in which the equity allocation decreases significantly over the following two decades, and finally maintain a much lower equity allocation during retirement.
Whether or not a declining glide path is justified from a risk and return point of view, the reality is that many people fear uncertainty more intensely as they approach retirement.
Risk feels greatest at the exact moment you retire
People report feeling like risks are greatest at the very moment retirement begins. One reason is that although you don’t know how long you’ll live, you do know that the present value of your retirement income needs is highest at the moment of retirement.
Another reason for this sense of increased risk at the point of retirement is that you become acutely aware of market volatility and the damage of drawing income during a bear market. The greater the market decline and the slower the recovery, the worse the effect on retirement income sustainability.
This knowledge adds to the stress of experiencing a market decline early in retirement and brings about fear of the act of rebalancing a portfolio in many retirees. Early in your life, rebalancing seemed counterintuitive enough, but in retirement the risk is that you will avoid it altogether.
A product to manage risk and fear
The traditional response to the real and perceived risks in the decumulation period is to own a low-risk portfolio. To achieve this, some people add a base layer of guaranteed income to their retirement income plan in the form of an annuity.
Annuities can play an efficient role in managing financial risk and longevity risk. The literature differs on when and how much to annuitize. But a common approach is to annuitize an amount that will generate a minimum income level to cover the essentials, while keeping the rest invested in a traditional portfolio. This assumes that enough wealth has been accumulated to make the approach work in terms of amount of income generated.
For most, an appropriate decumulation strategy would satisfy the following requirements:
Maintain expected investment income
Reduce the effects of a market correction, especially if it occurs early
Allow for enough liquidity in the portfolio to meet unexpected expenses
Help manage fears during financial crises, thereby improving the likelihood that the rebalancing strategy will be followed with greater discipline
A practical way to satisfy several of these requirements may be to incorporate an annuity contract with a minimum payout guarantee into the portfolio mix.
Another Challenge: Uncertainty in Life Expectancy
Longevity risk is the risk of living longer than expected and of depleting financial resources. In the face of longevity risk, you’d ideally consume in proportion to your survival probabilities. This is as opposed to withdrawing a constant amount of income for life.
A decumulation policy should periodically re-evaluate whether the current level of income payout can be maintained or should be adjusted. Ideally, you’d want to have flexibility to live with adjustments in income when facing uncertain returns. Small income adjustments planned well in advance can reduce longevity risk.
Problem is, many people could not tolerate a surprise downward adjustment of income or modify their lifestyle as quickly as needed. Most have fixed commitments. Your realistic decumulation approach should consider your tolerance level in adjusting your income needs.
Evolution of Income Needs
Several factors affect income needs as you move into retirement. Many ask what happens to typical household expenditures at retirement and over time. A common assumption is that the income required at the point of retirement increases yearly by the inflation rate.
Most older studies examining the transition from work to retirement found a decrease in household expenditures within the first two years after retirement ranging from a decrease of 4% to a decrease of 17%.
More recent studies using a broader definition of consumption data that incorporates housing costs, food, transportation, apparel, medical care, entertainment, and other items find that consumption expenditures fall by about 2.5% in the first year of retirement and then continue to decline by approximately 1% a year afterward.
Several studies observed that the decline in spending during retirement is mostly limited to the categories of food and work-related expenses. One hypothesis for this is that the lower amount spent on food is due to increased shopping diligence and more time spent cooking at home. Some expenses do typically increase during retirement, however, such as those for entertainment and travel.
The best approach is to properly monitor your expenditures as retirement nears (say, for 5 years or so) to better understand your consumption patterns and what to expect after retirement.
Decumulation is more challenging than accumulation
Decumulation is a more challenging process than accumulation because the options available to retirees are more limited. Also, the uncertainty is greater and more impactful.
You can decide when to retire but you have less control over how long you will live.
You will be penalized by market volatility during the decumulation period.
You have greater control over how much you save pre-retirement than how much you spend post retirement. That’s because you will need a specific level of income to sustain your lifestyle and meet fixed commitments.
You will likely have low tolerance for a significant reduction in retirement income, both practically and emotionally.
What helps is an integrated retirement-planning process that can meet your goals in an uncertain world. An important exercise is to delineate the factors under your control and the factors not under your control and assess the acceptability. Then you look at tools that help move the uncontrolled factors under your control or manage those factors otherwise.
The objective of these exercises should be to help you make decisions grounded in reality in your own situation and personality. Yet you want to avoid catering to your own misguided fears. You don’t want to fall into the trap of making yourself feel good about your retirement income by assuming a magically high expected return. You don’t want to appease yourself by finding a retirement income calculator that allows you to tweak your expected return assumptions until you get the number that you like. That would be just as imprudent as planning an arbitrarily earlier age of death and then claiming that retirement has suddenly become feasible.
This raises the issue of the (a) sustainability and (b) feasibility of retirement.
Sustainability is about the likelihood that the income objective can be met in the long run considering the key uncertainties of asset returns and longevity.
Feasibility is about the portfolio’s ability to fund the desired cash flows in the first place. Is the retirement income objective reasonable and rational considering the current wealth, savings rate, other sources of income, and reasonable expectations of returns and inflation?
An effective retirement income strategy is not solely about implementing investment and risk management processes. It starts with the ability to gain a clear financial picture for yourself. Is your retirement ambition realistic? What trade-offs are available that increase the likelihood of reaching your goals?
Although the number of aspects to be integrated in the process is substantial and creates complexity, every piece is essential for your success.
