Last month, in our blog The 60/40 Investment Debate, we discussed a few key considerations when it comes to longevity risk. As our focus continues in a pursuit to solve this very important issue, we realize longevity planning is often confused with traditional planning for one’s future retirement.
For most, today’s retirement planning only focuses on planning “to” retirement rather than “through” retirement. Financial planners generally do a good job of putting focus on the accumulation years before retirement; sometimes using rules of thumb for the subsequent post retirement years. One popular example is the well-known 4% Retirement Rule, which was first stated by William Bengen’s 1994 paper. This framework used historical data to determine “safe” rates of withdrawal from a portfolio. How many times have we heard, “Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4%, followed by inflation-adjusted withdrawals in subsequent years, should be safe.”
What’s the biggest assumption underlying the 4% rule?
It is neither investment returns, nor the longevity of the retiree. It is the presumption that the retiree won’t withdraw more than 4% of the initial asset balance each year. To be sure, investors could always withdrawal less than 4% and cut back on essentials in the case of poor investment performance. But without knowing how much they’ll need later in life; the decision is filled with uncertainty. Regardless, it seems retirees may not even adhere to the 4% rule when you consider actual behavior. While the 4% rule may not be realistic, many scholars and marketers quickly adapted Bengen’s research. In years that followed, its simple approach made it popular. Since nobody knows how long they will live, planning decumulation around actuarial averages results in a retirement income strategy that may lack precision.
But investors ideally need a roadmap that considers all phases of life. Predicting the length of the journey may be difficult, but one can still plan for all possibilities, matching the inflow and outflow of assets over the totality of retirement. Conventional financial wisdom reveals the path to retirement, but the road through it still needs to be made. Since nobody knows their exact retirement income needs, investors need to build a conservative margin in their household balance sheet to fund any unexpected expenses from longevity. This may come from their investment portfolio or through a custom insurance solution to share in the risk.
Source: One-Year Treasury Constant Maturity (DGSI) from FRED website 11/1/2018. Past results are no guarantee of future results.
How Much Risk Are You Willing to Accept?
Since the size of the cushion has profound implications for the retiree’s financial well-being, it should depend on how averse the investor is to longevity risk. Those who save too little, risk hardship or forced dependence, whereas those who save too much may experience unnecessary deprivation. If you factor in sequence of returns risk as well as a low interest rate world (as highlighted in the chart above) , this will require additional consideration for most investors as they look to create wealth, generate income, and manage portfolio risk at retirement.
Can any asset allocation address longevity risk? By building a cushion, the investor may be able to reduce the investment risk portion of the income risk, but no traditional asset has the capability of insuring against longevity risk. Hence, the investor can tweak asset allocations forever to arrive at an “efficient” portfolio from an investment risk perspective, but the exclusive use of traditional assets leaves an entire source of risk unaddressed. The investor unnecessarily hinders his or her portfolio efficiency. Put bluntly it is impossible to have an optimal income efficient portfolio if the underlying assets’ investment strategy cannot address all the risk.
As always, we appreciate our relationship with you and we are here to help.