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, but fewer investors put the same amount of weight on the possibility of outliving their savings.

We’ll start with a condensed overview, followed by a case study for a deeper dive.

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, but 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, while the fixed-income position is established to generate income and provide a ballast to soften volatility from the stock allocation.

Results Take Time

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

The Balanced Investment approach ends with more than $1.5 million, having funded more than $1 million in distributions over the twenty-year period.

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 next five or six years of expenses to fixed income
3. Any money you won’t spend for the next seven years to equities

Implementing a “bucketing” strategy can create peace of mind knowing your short-term needs will be provided for through the less volatile assets, while the equity portion of the portfolio can be left untouched, providing growth to fund the later years of retirement. See 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 in 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 people move through their working lives and near retirement, portfolios should be repositioned to be less exposed to risk assets. In general, this may be an appropriate methodology, although it’s difficult to peg a specific strategy as the ideal approach since all financial plans are different.

There oftentimes is a misperception among those at the doorstep of retirement or those just recently retired who believe that now all risk must be taken off the table. There can be a prevalence of fear among recent retirees that, because of 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 into lower-risk, lower-returning assets.

Depending on the amount of money saved for retirement, and the anticipated annual drawdown of those assets, this strategy might work. For some who have saved extremely well, and who plan to spend very little in retirement, they may have enough to fund their lifestyle with no further accumulation coming from income or appreciation on those assets. However, for many others, some aspect of growth is still required to fund 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 for the duration of 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 spend of their retirement assets ($40,000 in the first year), and then increased that spend by inflation 2.5% over the course of the next twenty years (resulting in an annual spend of approximately $65,000 in the final year).

In the balanced investments approach (blue line) above, the retiree invested 60% of their portfolio into a diversified stock strategy and 40% of their portfolio in a diversified bond strategy.  The cash scenario (orange line) represents a retiree leaving the savings in a cash equivalent account. 

The Risk of Exiting

There are a few points that can be taken from the graph. The first is that, yes, there are periods of time in which a balanced portfolio could experience a decline in value significant enough to deplete the savings below the principal amount. The Great Recession (2007-2009) would have been one of those instances. The stock market, as measured by the S&P 500, fell almost 57% at the worst point. In the sample strategy above, the 40% exposure to bonds softened that loss, but the portfolio still experienced a decline 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-year period.

Cash Strategy & Inflation

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

Additionally, this scenario does not provide for any expenses outside of the fixed distribution (4% + inflation). In reality, it is likely that there would be higher recurring costs for medical expenses, vehicle purchases, home repair, etc. 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 be able 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 declines the longer the time horizon is extended. Within the span of about a month-and-a-half in 2020, the stock market declined by 37%. That decline is noticeable in the graph below, but you’ll also see the impact to 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 at that point in time 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

19 years after retiring, and immediately after experiencing a significant market decline, the retiree with the Balanced Investment Strategy had approximately $400,000 more in savings than when they retired and started drawing down the portfolio. Although the investment allocation never changes throughout the period, the risk—at least as it relates to a 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 isn’t sufficient exposure to equities.  The graphs above represent a balanced portfolio (60% equities / 40% fixed income).   

If you removed the return from the 60% equity exposure, 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 difficult to take on risk—even a balanced approach to risk.  An often-recommended approach to manage investment assets in retirement is to “bucket” three primary assets according to the anticipated time horizon (time until 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 year one 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 he or she would not have to consider selling the stock portion of the portfolio for six years following the date of retirement.  

This strategy would obviously result in higher equity exposure (76%) than the Balanced Investment Strategy utilized 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 can be advantageous to continue thinking long-term strategy at the outset of retirement.  It’s also important 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 honored to meet with you and talk through potential solutions to meet your retirement goals. Contact us here when you’re ready.