Risk in Retirement

New or soon-to-be retirees can easily fall into the trap of thinking that they are no longer "long-term investors." Assuming an average life expectancy, most retirees should be prepared to fund 20 to 30 years of retirement, which very much requires a long-term investment strategy. Many recent retirees will openly discuss their fear of losing all their retirement savings in a market event. Still, fewer investors put the same amount of weight on the possibility of outliving their savings.

We'll begin with a concise overview, followed by a case study for a more in-depth examination.

Risk in Cash Savings

Overcorrecting based on this fear and pulling back on risk assets completely can risk prematurely depleting your savings. The inability of cash (or cash equivalent assets) to generate any material long-term growth to fund the later stages of retirement is one thing. Still, when inflation is factored in, it's even less likely that cash savings provide a viable long-term solution.

Balanced Portfolio for Growth

A balanced portfolio has historically provided investors the benefit of consistent risk-adjusted growth over a long time horizon. The equity portion of the portfolio is generally the growth component. At the same time, the fixed-income position is established to generate income and provide a ballast to soften volatility from the stock allocation.

Results Take Time

Within a given one-year period, the probability of stock market losses is substantial. Over ten years, that probability lessens, and the degree of those potential losses (relative to the principal investment) is less consequential. Over 20 years, the market (as measured by the S&P 500) has historically generated positive returns. In the test case below, the retiree had been invested for a sufficient period that when the market declined by 37% in 2020, the portfolio balance remained well above the original investment amount and significantly above the then-depleted cash equivalents.

Bucketing Approach

A bucketing strategy for retirement savings involves dividing your investments into "buckets" based on time horizon and risk tolerance. You may have short-term buckets for immediate needs, medium-term buckets for upcoming expenses, and long-term buckets for future growth. There may be varying levels of risk in each bucket.

An example of bucket allocations:

1. One or two years' worth of expenses to a money market fund
2. The following five or six years of costs are fixed income
3. Any money you won't spend for the next seven years on equities

Implementing a "bucketing" strategy can create peace of mind, knowing that your short-term needs will be met through less volatile assets. At the same time, the equity portion of the portfolio can remain untouched, allowing it to grow and fund the later years of retirement. See the sample approach below.

Misconceptions About Risk in Retirement Planning

When planning for retirement, it's common knowledge that most people will have to take on a certain level of risk to accumulate enough assets to fund their retirement. A common perception is that younger people can take on more risk (i.e., stock market exposure), and that as individuals progress through their working lives and approach retirement, their portfolios should be repositioned to be less exposed to risk assets. In general, this methodology may be appropriate, although it's difficult to pinpoint a specific strategy as the ideal approach, as all financial plans are unique.

There is often a misperception among those approaching retirement or those who have recently retired that all risk must now be eliminated. There can be a prevalence of fear among recent retirees, as they worry that, due to the loss of their income stream, they "can't afford to lose it all" (meaning their retirement savings). They then take steps to lock down their balance sheet by investing in lower-risk, lower-returning assets.

Depending on the amount of money saved for retirement and the anticipated annual drawdown of those assets, this strategy may be effective. For those who have saved extremely well and plan to spend very little in retirement, they may have enough to fund their lifestyle with no further accumulation needed from income or asset appreciation. However, for many others, some aspect of growth is still required to invest 20 or 30 more years of living expenses. For this reason, it's often the case that some degree of market exposure must be maintained throughout retirement.

Case Study: $1MM at Start of Retirement

Balanced Investments vs. Cash

The chart below demonstrates a sample case of an individual who retired in 2003 with a nest egg of $1 million. The retiree instituted a 4% annual withdrawal from their retirement assets ($40,000 in the first year), and then increased that withdrawal by inflation (2.5% over the next twenty years), resulting in an annual withdrawal of approximately $65,000 in the final year.

The Risk of Exiting

Several key points can be inferred from the graph. The first is that, yes, there are periods in which a balanced portfolio could experience a significant decline in value, potentially depleting the savings below the principal amount. The Great Recession (2007-2009) would have been one such instance. The stock market, as measured by the S&P 500, reached its lowest point, with a decline of almost 57%. In the sample strategy above, the 40% exposure to bonds softened that loss, but the portfolio still experienced a drop of more than 32%. If the retiree of the balanced investment strategy decided at that point to exit the investments and go to a cash equivalent product, the loss would have been realized and locked in. For those who remained invested, it is apparent that the portfolio recovered within a few years and was able to fund the retirement spend for the remainder of the 20 years.

Cash Strategy & Inflation

The second point is how precipitously the cash strategy declines throughout the period. In this scenario, the ending balance was $176,903. Hypothetically, this approach may have been feasible for providing for a retiree's life expectancy. However, assuming a retirement age of 65, the retiree may live past the age of 85 (20 years), in which case the probability of portfolio depletion increases as expenses continue and adjust upwards to match inflation.

Additionally, this scenario does not account for any expenses beyond the fixed distribution (4% + inflation). In reality, there would likely be higher recurring costs for medical expenses, vehicle purchases, home repairs, and so on, that would expedite the decline. While those expenses are also not included in the Balanced Investment Strategy, it is apparent from the graph that, between the two, the balanced approach is more likely to sustain those more significant, periodic drawdowns.

Time Horizon Factor

The final point to derive from the graph is that the risk of losing the principal investment amount decreases as the time horizon is extended. Within about a month and a half in 2020, the stock market declined by 37%. That decline is noticeable in the graph below. Still, you'll also see that the impact of the Balanced Investment Strategy did not bring the portfolio balance anywhere close to the principal investment of $1 million.

The spread between the Balanced Investment Strategy and the Cash Strategy, then, is even larger, as the cash had by then been depleted well below the initial starting value. We see a similar instance with the decline in 2022, when the market (S&P 500) was down more than 18%. The Balanced Investment Strategy declined significantly, but never below $1.4 million.

The Final Math

Nineteen years after retiring, and immediately following a significant market decline, the retiree with the Balanced Investment Strategy had approximately $400,000 more in savings than when they retired and began drawing down the portfolio. Although the investment allocation remains unchanged throughout the period, the risk—at least as it relates to depletion below the original principal—declines.

Equity Exposure

Research has shown that if a 4% annual withdrawal is initiated at the beginning of a 30-year retirement period and increased annually by inflation, the probability of success in funding the retirement period decreases materially if there is insufficient exposure to equities. The graphs above represent a balanced portfolio (60% equities / 40% fixed income).   

Suppose you removed the return from the 60% equity exposure. In that case, you'll note that—while the bond portfolio withstands the drawdown better than the cash equivalent approach—the margin for error narrows in comparison to the balanced portfolio. (As mentioned above, while these projections account for inflation on the percentage withdrawal, they do not account for extraordinary lump-sum expenditures such as a vehicle purchase or medical expense. Additionally, the period examined represents only 20 years, which may be compressed depending on the situation.  

Sample Bucketing Approach

Despite knowing the information and seeing it represented through the data, it can still be challenging to take on risk, even a balanced approach to risk. An often-recommended approach to managing investment assets in retirement is to "bucket" three primary holdings according to the anticipated time horizon (i.e., the time until they are spent). Moving forward with the same scenario: if the retiree began retirement with $1 million and anticipated to draw it down by $40,000 per year, they might structure their savings as follows: 

This approach would allocate $60,000 to a cash equivalent product to provide for the first 18 months of expenses.   Therefore, during the first 1.5 years of retirement, the retiree can have peace of mind knowing that, regardless of how markets are performing, their expenses are covered for that timeframe.   

While fixed income investments (bonds) may fluctuate in value, the volatility (historically speaking) is generally not to the degree of what has been observed in the stock market.   Therefore, the retiree can have assurance that, for the next five years (following the year of retirement), the assets will be available and will likely generate a higher return than they would have received in cash-equivalent products. From this perspective, the retiree would also have peace of mind knowing that they would not have to consider selling the stock portion of the portfolio for six years following the date of retirement.  

This strategy would result in higher equity exposure (76%) compared to the Balanced Investment Strategy used in the graph above. From that perspective, a 60/40 investment objective would be considered a fairly conservative approach, if viewed through the lens that $400,000 in fixed income would cover ten years of retirement expenses ($40,000/year; not adjusted for performance or inflation).  

Opportunity Cost

As you can see, it is advantageous to consider a long-term strategy at the outset of retirement. It's also essential to account for the opportunity cost of not allocating a reasonable portion of long-term money to higher-returning asset classes.  Consider what higher returns could accomplish for you in retirement, for your family's future, or perhaps by way of charitable bequest. 

Here to Guide You

Managing risk is a complex task.   It is advisable to work with a competent team, including a financial advisor, attorney, accountant, and insurance professional, to ensure that risks are being managed and planned for.

Here at First Financial Trust, one of our relationship managers would be delighted to meet with you and discuss potential solutions to help you achieve your retirement goals.  Please get in touch with us when you're ready.