Retirement planning is largely about setting expectations, trying to manage risks or uncertainties and increase the probabilities of a successful retirement as it is defined by each client. The Society of Actuaries accounts for 15 risks overall, which are in a report on my website. For today’s purposes, I’m going to concentrate on “longevity risk” and “sequence risk.”
Longevity risk refers to the risk of outliving your assets, resulting in a lower standard of living, reduced care, or a return to employment. You don’t know how long you will live, and while you would prefer to live longer, it is costly and a drain on your resources.
Sequence risk is a form of market risk that comes from receiving lower or negative returns early in a period when withdrawals are made from the underlying investments. Market returns in the early years of retirement matter the most, because your wealth can be depleted to the point that it can’t benefit from any subsequent recovery in later years.
If we plot these two risks on a matrix, we find four potential outcomes
If we plot these two risks on a matrix, we would find four potential outcomes: 1) High market returns with high longevity (awesome), 2) High market returns with low longevity (bummer), 3) Low market returns with low longevity (rats) and lastly 4) Low market returns with high longevity (uh oh). The first is ideal, the second leaves a large inheritance, the third is bad luck, but the fourth can be big trouble.
Focusing first on longevity risk – no surprise here – we’re living longer! According to the Census Bureau, the U.S. average life expectancy at birth increased 62 percent from 47.3 years in 1902 to 76.8 years in 2000, with expectations it will reach 79.5 years in 2020. Life expectancy is an average meaning half of us will live shorter and half will live longer lives. The Society of Actuaries has found more than half of Americans underestimate their life expectancy, and their financial planning time horizons are too short.
Shifting to sequence risk: I won’t try and predict market directions over the short term, but the general consensus is that we are entering period of subdued returns. Vanguard published their expectations for a balanced portfolio to average a low 4 percent return over the next 10 years. According to Blackrock, one of the largest money managers in the world, in their Q2 2016 Outlook:
We are living in a low-return world.
“We are living in a low-return world. Quantitative easing (QE) and negative interest rate policies have inflated financial markets. Many assets have had a great run since the financial crisis. This means future returns are likely to be more muted. We have been borrowing from the future.”
The implications here are that a new retiree will face a strong possibility of lower returns combined with a longer retirement. Combine this with fewer pensions to offset retirement costs, and you have the modern retiree dilemma.
Successfully navigating such an environment will require a good process, stress testing and discipline. Rules of thumb – such as the 4 percent rule or subtract your age from 100 — can do more harm than good as they are too conceptual and the underlying assumptions do not align the current environment. Start with planning and run every possible portfolio combination to see which ones have the greatest impact. Consider alternatives to traditional thinking but make sure any approach is well diversified, provides for an income stream throughout life, has sufficient liquidity for the unexpected and includes inflation protection for the inevitable escalation in the costs of living.
Gardner Sherrill, CFP®, MBA, is an independent financial adviser with Sherrill Wealth Management. To learn more visit sherrillwealth.com. The opinions expressed in this material are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. There is no guarantee that a diversified portfolio will enhance overall returns or out perform and non-diversified portfolio. Diversification does not protect against market risk. Securities and advisory services offered through LPL Financial a registered investment advisor. Member FINRA/SIPC.