Most likely you have been saving and investing money to build up wealth all your life. But no matter how well you do in the ‘accumulation phase’, there comes a time when your goal will switch over to creating a sustainable retirement income that will last as long as you need it.
The last statement is the hardest to achieve. How long do you need it to last?
Attaining this goal can be difficult because there are a host of new risks in the ‘de-cumulation’ period. Creating a steady income is an art.
The good news is that with the right tools and strategies in place you can reduce or even eliminate many retirement risks. It’s possible to live a much more comfortable and stress-free retirement secure in the knowledge that income will continue to be received for as long as you need it.
The 7 Key Risks in Retirement – And How to Reduce Them for Portfolio Stability
We face risk of all kinds throughout our lives. But when it comes to retirement, there are seven key financial risks that, if not attended to early, can significantly alter the course of your income, and in turn, the lifestyle that you end up living. In some cases, this can even equate to a substantial reduction in the amount of income that is anticipated…at a time when you need it the most.
Let’s take a closer look at each of these retirement risks:
1. Market Volatility
First and foremost, market volatility is actually a financial risk that is faced by anyone who is invested in equities and/or market-related instruments. At younger ages, though, it can be possible to “wait it out” and allow time for your portfolio to bounce back (although there is certainly no guarantee that it ever will). As you approach retirement, though, even a slight dip in the value of your portfolio can be the cause of lost income for the remainder of your lifetime.
Inflation is another key risk that is present throughout your life. But here again, during your working years, it is possible that your income will rise over time in order to help you keep your purchasing power on pace with the rising cost of goods and services that you buy. During retirement, however, there is no guarantee of this unless you plan for it – and not planning for inflation could result is having to cut back on buying items and services that you need. As an example of just how much inflation can impact your purchasing power, let’s take a look at an example. Using an inflation rate of just over 3%, your income would have to double over a 20 year period of time just to keep your purchasing power on track. So, if you’re currently receiving $5,000 per month from your investments, in 20 years you would need secure roughly $10,000 in monthly income in order to stay on track.
3. Low-Interest Rates
Over the past decade or so, the U.S. has been in the throws of a historically low-interest rate environment. And, while this can be beneficial for those who are borrowing money, the same cannot be said for those who are relying on “traditional” income-producing investments like bonds. Unfortunately, though, “balancing” out a bond-heavy portfolio with equities can subject you to more volatility (which is described above).
4. Sequence of Returns / Order of Returns
The return that you get on your money is important – but so is the order, or the sequence, in which you receive those returns. For instance, if two retirees each attain a 7% return over a 20 year period of time, will they both be able to count on their money lasting for the same amount of time. Nope! That’s because the order in which you receive your returns can make a tremendous difference.
Let’s take a look at another example here. Using a portfolio with an initial investment of $100,000 and a 9% annual withdrawal rate, both of the portfolios shown below had an average overall return of 7%.
However, because Portfolio #1 had a negative return in Year 2 as opposed to in Year 3, it was depleted six years earlier than Portfolio #2 – all other factors being equal. Because of that, once you begin to take withdrawals from your portfolio – and even in the few years leading up to that time – it is essential that you are even more mindful of not just the overall return on your money, but also the order in which those returns are received.
|Year 1||Year 2||Year 3||Ave. Return||Years Until Depleted|
Source: Government Accountability Office, June 2011
5. Health Care Costs
As people age, it’s no secret that health care needs will usually increase, along with related health care expenses. According to a recent study from Fidelity, it is estimated that the average couple will need $280,000 in today’s dollars for medical expenses in retirement – and that doesn’t even include the cost of long-term care! So, if you also require long-term care services, you can plan on spending much, much more. Based on Genworth’s 2018 cost of care survey, the average price tag for a semi-private room in a nursing home was more than $89,000 (in 2018). Even homemaker services and home health aide services come in at an average of between $48,000 and $50,000 annually. Without some type of steady income in place, how will you be able to swing these expenses?
Taxes bring about yet another risk in retirement. Even though most of us pay taxes all of our lives, they can hit particularly hard in retirement. And don’t believe the financial advisors who tell you that you’ll be in a lower tax bracket during your retirement years, because that is not the case for everyone. In fact, there are some retirees who, based on the amount of income they have coming in, can actually be in a higher income tax bracket after they leave the world of employment.
While longevity might initially sound like a good thing, as living a nice long life can equate to more time spent with loved ones, the reality is that longevity could very well be the biggest risk of all to your retirement. That’s because when you live longer, you are subject to all of the above risks for a longer period of time. But there are strategies that you can implement that will not only help to mitigate volatility in your portfolio, but that can also ensure that you don’t run out of income down the road. One of the most stable and predictable methods includes the use of annuities.
Why Use Annuities in Lieu of Bonds to Reduce Portfolio Volatility and Increase Stability?
During the “saving and investing for the future” years, there are typically some rules of thumb like ‘120 minus your age’ for your bond allocation that are followed by investors. Like any rule, this should be tempered liberally with a dose of salt, however it is true that equities carry higher potential risk and they can also provide the opportunity for a higher return.
The younger you are the greater your ability to take on risk and to recover from adverse market performance. But as you age, you need to depend on your your money to produce income in retirement, and you can not afford to take on risk. As a retiree, you must manage financial risks such as market performance, along with your own longevity, as well as the uncertainty about your spending requirements.
Traditionally, many retirees have chosen bonds for producing some – or even all – of their retirement income. But just because something has “always been done” a certain way, it doesn’t mean that a better solution may be out there.
Today, there is – with annuities. In fact, when properly purchased, an annuity can provide you with a guaranteed stream of income in retirement, regardless of how long you may need it. And with many annuities, the amount of that income is fixed, no matter what occurs in the stock market. The same cannot be said about relying on bonds, and certainly not about portfolio “drawdown” strategies.
Wade Pfau – a known expert in the retirement income space – refers to annuities as “actuarial bonds,” because annuities have the potential to improve retirement outcomes over what is possible, even with bond funds.
Pfau goes on to state that:
“Lifetime risk can be framed simply as the possible shortfall in the amount you will need to spend, which can happen when market returns are bad or your life is unusually long.
Reward, on the other hand, can be defined by any liquid financial assets that is available to support your additional spending for contingencies or to fund legacy objectives when you have otherwise been able to meet your lifestyle spending goals.”
Based on this, Pfau has concluded that the combinations of stocks and income annuities produce more efficient outcomes than combinations of stocks and bonds. In fact, income annuities can effectively serve as a replacement for the fixed-income allocation in a retirement portfolio.
There are actually several reasons for this, as well. First, unlike bonds, annuities don’t “mature.” In fact, bonds can be sold such that you get your money back with either a gain or a loss, based upon how interest rates have moved since you purchased them.
This, however, is not the case with an annuity. So, there is no need to worry about having to lock in at a lower rate (and in turn, a lower income stream) down the road with an annuity. Due to market fluctuations, the actual value of a bond itself can go down, based on what is happening in the market – essentially impacting the amount that you could sell a bond for in the marketplace if you needed to liquidate it. This, too, is not the case with an annuity.
But, because most annuities allow you to withdraw a certain amount of money penalty-free, you still have access to liquid dollars if they are needed for emergencies – or even to supplement other retirement income sources if necessary.
Pfau’s research has also shown that liquid financial assets can be larger later in retirement if you have some of your portfolios in annuities. Initially, your portfolio’s liquid assets can take a hit when you purchase an annuity. However, they can eventually catch up. And, because annuities can provide more income than bonds, less money needs to be withdrawn from the portfolio.
Much like a “personal” defined pension plan, annuities essentially provide value to their owners by pooling risk across a large base of participants – and one of the biggest risks that an annuity can solve for is “living too long.” No other investment vehicle can do that.
Neutralizing Volatility and Uncertainty
It goes without saying that the constant ups and downs of the market can create uncertainty – not only about your money now, but also about your retirement income later. And there doesn’t necessarily have to be a major market correction for this concern to occur. That’s because even slight market hiccups can be the catalyst for large losses, and in turn, reduced financial stability.
With four of the most financial goals for retirees being lifestyle, longevity, liquidity, and legacy, an annuity can solve for all of these. That being said, though, the right annuity must be purchased.
For instance, for income later in life, a deferred income annuity, or DIA, can be an ideal solution. DIAs, which provide income later in life, can actually make a lot of sense, because as people age, their payments increase. This, in turn, can help with combating a number of common retirement risks, including inflation and health care expenses, as well as solving for longevity risk.
And, according to Moshe Milevsky, Ph.D., an expert in retirement income concepts, despite the perception that this type of annuity is a relatively new or novel income concept, the reality is that this concept has actually been around for hundreds of years.
As far back as the 17th century, income annuities were used to help finance retirement by generating a regular stream of income, which in turn, acted as a hedge against longevity risk for the recipient.
But today’s more “modern” DIA takes the concept of mortality credits (i.e., the concept of those who live longer benefitting from the deferred income annuity’s income) to the next level. It does so by reaching out further on the “time curve” in order to credit higher interest to the recipient.
Milevsky states that there are certainly several strong similarities between long-term bonds and deferred income annuities. For instance, both of these financial instruments can be sensitive to long-term interest rates. However, the mortality credits that are associated with the annuity can provide retirees with an added buffer.
According to Milevsky, the average age that purchasers start buying deferred income annuities is just slightly before age 60. The average deferral or delay period – which is the number of years between the purchase age and the age at which the income is expected to begin – is 7.2 years.
Due to their sustainability and predictability, then, Milevsky suggests that individuals who are approaching retirement age should “swap out” some of their fixed-income holdings (such as bonds) and replace them with deferred income annuities (DIAs).
And where exactly should investors obtain the money to purchase deferred income annuities? Why of course, from their long-term fixed income holdings like bonds!
How to Choose the Right Annuity for Your Income, Safety, and Growth Objectives
While the argument for annuities versus bonds in retirement is a strong one, it is important to be careful that you don’t just choose any annuity. That’s because there is a wide range of different types of annuity products, including some that have a myriad of “bells and whistles” (which are oftentimes unnecessary) that can make the product more expensive and much more complicated than it needs to be.
With that in mind, make sure that you compare annuities with an insurance professional who specializes in these financial vehicles and who can point you in the right direction. At DCFAnnuities, our focus is on deconstructing annuities so that you see exactly how they work, and how they could work for you.
We work only with trusted and highly rated insurance carriers that offer annuities, which can help to ensure that your money is safe, and that your income is reliable – regardless of whether it will start now or at some time in the future. Contact DCFAnnuities for more details on putting a safe and solid income stream in place.