Investors at every stage in life should be keeping a careful eye on risk—but limiting your exposure to risk is particularly important when you shift from building retirement wealth to actually living on that money.
That’s because the distribution phase, as it’s sometimes called, is a tricky juncture where you have to address competing goals. On the one hand, you need to preserve the savings you’ve worked so hard to build. On the other hand, you still need some exposure to risk if you want your savings to keep up with inflation and grow enough to last through a potentially long retirement.
And market risk isn’t the only type of risk you’ll have to manage as you enter retirement. Here are three others:
- Longevity risk. This is the risk that you’ll outlive your savings. The latest research on longevity shows that today’s 65-year-olds have a 50% chance of living past their mid-80s. Many financial planners use age 90 as an estimate, but it’s best for each individual to gauge how long he or she might live.
- Loss aversion risk. Your instincts may tell you to avoid losses. But if you’re too sensitive to losses, it could have a negative long-term effect on your investments. Being aware of how fear can color your choices can help you make better decisions.
- Sequence-of-returns risk. This is a big one. In essence: If the market dips during early retirement—when you’re first taking withdrawals—it can be harder for your portfolio to potentially recover than if you sustain losses later in retirement.
Understanding sequence risk
At Schwab, we think the best time to add downside protection is when volatility is low and markets are high. We’re bullish on the current cycle for U.S. equities, and on a well-diversified portfolio invested for the long term. However, we also expect heightened volatility through the remainder of 2016, given current market and economic dynamics, and that could increase sequence-of-returns risk for anyone beginning to take withdrawals.
The table below depicts two hypothetical retirees, Marcus and Susan, each with a $1 million portfolio. They both withdraw $50,000 in year one of retirement and gradually increase their withdrawals for 20 years to keep up with inflation. The difference is that for Marcus, the stock market falls 15% in each of the first three years of retirement and grows 10% per year thereafter. Susan has 10% annual returns at first, then three years of 15% annual losses at the end of the 20-year period.
As you can see, Susan’s total loss from those down years is greater than Marcus’s—his portfolio lost about $500,000, while hers dropped by about $1.1 million. But the real story is that Marcus runs out of money in year 18, while Susan still has $1.34 million left in year 20—all because of a difference in the timing of those bad years.
Think of retirement distributions as the reverse of dollar-cost averaging (that is, when you invest a fixed amount at regular intervals, which allows you to buy more shares when the market is down, fewer when it’s up). When your portfolio’s value is lower, you have to sell more shares to get the same amount of cash—leaving you with fewer shares to compound in the future.
In this example, Marcus’s portfolio is permanently hampered by early losses, while Susan’s portfolio has plenty of time to grow (in both dollar value and number of shares) before losses occur.
It would be nice if you could just delay having years of negative returns until later in retirement, but of course, no one can predict that—which is why understanding how to cope with sequence of returns and other downside risk factors is so important, especially right now.
The economic environment right now
First, let’s look at stocks. They’ve had a big run: At the beginning of July 2016, the S&P 500® Total Return Index was up over 242% (nearly 18% annualized) from the market bottom in March 2009. When select markets perform well for a sustained period, it is a good time to revisit your risk and focus on protecting the downside of your portfolio. That doesn’t mean you need to be wary of an imminent downturn if you’re invested for the long-term, but a strong defense may help protect the growth you’ve enjoyed.
Next, there’s the bond market. Bond yields are very low. That limits the ability for bond investments to generate strong total returns going forward.
The Fed is transitioning from a cycle of loose monetary policy to tightening for the first time in seven years. We believe that diverging global monetary policies—that is, tightening in the U.S., and loosening in Europe, China and Japan—could increase volatility across global markets.
Britain’s recent “Brexit” vote, negative interest rates in many developed countries, and uncertainty about global growth have led to sharp market dips and rebounds, increasing risk in our view.
The prospect of increased volatility makes this an especially smart time for investors nearing or in the early years of retirement to consider adding downside protection to their retirement strategy.
Ways to add downside protection
One classic form of asset protection is to divide your portfolio into “buckets”: For example, you could invest one portion in relatively safe, liquid assets, providing you with cash flow for the next few years. Then the second bucket is invested for long-term growth, based on your risk tolerance.
There are different ways to think about these subdivisions, as you can see in this video, but the general idea is to have enough cash to cover you in the event of a downturn—which gives the growth portion of your portfolio the chance to recover when the market does. Over the past 50 years, it took the S&P 500 slightly more than three years, on average, to recover from a downturn.
The second downside strategy to consider is the purchase of an annuity, which can act as a form of retirement income insurance. Typically, the size of your payout is based on your age and prevailing interest rates at the time of purchase, as well as the amount of your one-time premium.
Insurance that protects your retirement income
Not all annuities are created equal. First, annuity guarantees depend on the financial strength and claims-paying ability of the issuing insurance company. Second, some annuities offer better protections—with less onerous fees—than others. Whether they make sense for you will depend on how comfortable, and able, you are to manage their specific risks, and the cost of doing so. We’ll focus on two types of annuities that can potentially deliver protection against downside risk at a fair cost:
- Fixed (or “single premium”) immediate annuity. With an immediate annuity you pay an insurer a premium, and then you’re guaranteed a fixed monthly payout, typically for the rest of your life or the life of your surviving spouse. The tradeoff for this cushion is that the money you invest in a fixed immediate annuity is no longer invested for growth.
- Variable annuity with a guaranteed lifetime withdrawal benefit. With a variable annuity you have some control over how your premium(s) are invested. Your insurance company will have a number of sub-accounts with different investment objectives for you to choose from. When you reach the “payout phase” in retirement, your payout is based in part on the underlying value of those sub-accounts. The advantage is that your money remains invested, and you choose the types of investments you want to own, so you have the potential to earn returns that can outpace inflation over time.
But sequence of returns risk is still a concern, and that’s where the guaranteed lifetime withdrawal benefit (GLWB) rider comes into play. For an additional cost, this optional rider sets a minimum level of annual withdrawals for life, even if the contract value falls to zero.
So, by purchasing this benefit, you are creating a floor for your retirement income that remains in effect even when markets are down. And it allows for the possibility that your payout can increase, if a rising market boosts your investments within the variable annuity. Note that the GLWB is not a contract value and not available for withdrawal like a cash value. Your actual contract value will decrease with each withdrawal.
Adding an annuity to your retirement strategy doesn’t have to be an all-or-nothing proposition. In fact, it is often wisest to commit just a portion of your retirement assets to an annuity. This money will be your guaranteed income stream while you invest the rest of your money for growth.
That’s the extra value of downside protection: It permits you to enjoy greater confidence that your income will last through what can be a very long life.