Make your retirement portfolio last by understanding these 6 risks—Part 1

By Dario Fusato, Savvly CEO

Part 1 of a 2-part series

For most people, retirement planning has two phases: accumulation and decumulation. Saving and spending.

During accumulation, the main focus is on reaching the highest possible dollar figure leading up to the day you plan to retire. It entails identifying your comfort level with risk and making the best possible investment choices within that level. And identifying the most efficient growth and taxation strategies while maximizing every opportunity presented along the way.?

As your targeted retirement date approaches, your risk comfort levels tend to decrease as the time to recuperate from losses gets shorter and shorter.

But another change is also occurring.?

Retirement typically means the end of earned income, whether as a paycheck or revenue from a business. Psychologically, it means the end of easy accumulation. And it means the start of spending down your nest egg. Your spend down in retirement depends on your wealth transfer philosophy. Do you plan on enjoying all of your accumulated retirement savings on your personal retirement lifestyle? Or do you plan on passing along assets to your heirs? Or something in between? Your preferences will affect your retirement outcomes.

But before that happens, six risks should be factored in when you restructure your retirement portfolio for the spending phase: longevity, inflation, sequencing, diversification, geopolitical, and healthcare.?

Let’s look at the first three of the six.

Longevity risk: the risk that you outlive your money

To know how much you can spend each year in retirement, you have to know how long your assets will have to fund your lifestyle. Longevity risk is the risk of running out of money.

?Longevity is one of the critical assumptions in retirement planning – and not one with an easy answer. The risk is two-fold. One risk is that you live longer than planned, run out of money, and be forced to rely solely on Social Security and the goodwill of family members.?

The other is that you don’t reach your planning horizon and underspend throughout your retirement, frugally sacrificing your quality of life unnecessarily.

Longevity planning usually starts with the average mortality for the overall population. But how do you know if you will live longer than the average – or die sooner? (Half the population will outlive that statistic average.) And if you are part of a couple, that uncertainty is even more significant.

You might look at your current health, your family’s health history and the quality of your health care resources. But you may also want to factor in your level of risk aversion. If you are more risk-averse, you may prefer a longer horizon, even if it means sacrificing your lifestyle. And if you are more of a risk-taker, you may prefer a shorter horizon, even if it means juggling spending later in retirement.

In any case, it is not a decision to make lightly.?

Inflation risk: the risk that your life in retirement becomes more expensive than planned

Headlines shout that inflation “has reared its ugly head.” But inflation has always played a role in retirement planning calculations. High or low, it can chip away at a retiree’s income by increasing the future cost of goods and services and eroding the value of the assets earmarked to meet those costs.

The question is what rate to use in retirement planning calculations.?

Say someone retired in 2020 at age 65 after working since 1975. The annual inflation rate over those 45 years averaged 3.8%. But rates are not constant, as can be seen in average rates per decade, for example. So timing is also essential.

Yet, even if today’s high rates settle back down quickly to the Federal Reserve’s targeted 2% per year, with compounding, the spending power of one’s retirement account can lose 40-50% over a 20- to 30-year retirement period.

Underestimating the inflation rate can have a devastating impact on long-term retirement calculations.

Sequence-of-return risk: the risk of mistiming your drawdowns

Once you enter the spending – or decumulation – phase of retirement planning, available resources will depend on the rate at which you withdraw from your portfolio and the pace at which your investments grow.

The 4% withdrawal rate has been the retirement planner’s mantra for decades. The theory was that by withdrawing 4% of each year’s balance of retirement assets and correcting the remainder for inflation, you would not deplete your portfolio for at least thirty years.

But the increase in life expectancy puts “thirty years of retirement” in doubt. And it may be challenging to match the returns used in the original calculations – made in the 1990s when interest rates were higher. For example, Morningstar has estimated a safe withdrawal rate of 3.3%, but with several provisos.

Beyond the risk of determining the wrong withdrawal rate is the sequence-of-returns risk. It isn’t about investment risk. Instead, it refers to the financial market behavior when you start your spending phase. Even if two portfolios have the same average returns over time, one where withdrawals start during a bear market will have worse results than one starting in a bull market.??

Markets are expected to go up and down, but the timing of outcomes is unpredictable. If a portfolio has negative returns when you first withdraw funds, you have less money left to benefit from the upswing when the market recovers, as it eventually will. Even a series of mildly recessionary years can have a marked impact on your long-term results.

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In financial planning, there’s a large emphasis on investing enough money for retirement and little attention paid to what happens after it begins. Retirement shouldn’t mark the end of smart investment management. Get the most out of your retirement by spending your savings as carefully as you built it by managing your risk.

Savvly is a new alternative investment that can help you and your adviser better manage risk in retirement. If you’re an adviser who would like to learn more about Savvly, book a 15 minute call with us.