This is the first in a series of articles on navigating retirement risks. These articles are based on our White Paper, Creating Sustainable Retirement Income in 401(k) Plans Using Managed Risk Funds, available at www.milliman.com/new401k. In the Paper, you will find detailed support for the issues discussed below.
Americans are living longer…and that creates issues for sustainable retirement income. Updated pension mortality tables from the Society of Actuaries show that the average life expectancy for males age 65 is now 21.6 years (to age 86.6) and for women, is 23.8 years (to age 88.8). Approximately half the population will live longer than those projections. While these new tables relate to private sector pension plans – the Society estimates that this could create a 4% to 8% increase in pension liabilities – the importance of the data should not be ignored by retirees who must rely on 401(k) savings to fund their retirement.
Living longer means needing your money to last longer in retirement. It also means that retirees need to invest their retirement money in a way that is sustainable, notwithstanding their withdrawals for living expenses. Based on the new mortality tables, the “average” person who retires at age 65 will need to make sure his money lasts for 22-24 years. But because many will outlive the average, prudence dictates planning on a longer period, perhaps 30 years or more.
To make your retirement savings last that long, it needs to be invested in a way that provides a reasonable return in excess of inflation, while avoiding the damaging effects of market volatility. Volatility can be especially harmful in the years immediately before or after retirement.
This volatility is generally called “sequence-of-returns” risk. There are other factors that affect whether a retiree’s funds will last, including the rate at which he withdraws money and inflation, but sequence-of-returns, or “timing,” risk will have a significant impact.
Timing risk arises when a retiree takes withdrawals – to pay living expenses in retirement – from a portfolio that is declining in value, for example, during the volatile securities markets of the early and late 2000s. The withdrawals in down markets have the effect of locking in losses, because the losses on the withdrawn money can never be recovered. Put in simple terms, if the market goes up when we retire, that’s good; if it is goes down, that’s bad. Unfortunately, when we retire we won’t know whether the markets over the next 5 or 10 years will be up or down. This emphasizes the need to dampen volatility while investing to capture market returns.
To understand the impact of timing risk, consider the annual returns of the S&P 500 Index (a common benchmark used to measure the performance of an equity-heavy portfolio) during the 14 year period from 2000-2013. The S&P 500 Index showed gains in 10 out of the 14 years (over 70% of the time), and losses in only four years (2000-2002 and 2008). Now consider examples of the impact of these gains and losses on a retiree (based on investments that track the Index).
Example 1: The individual retires in 2000, at the beginning of a period of market losses. He has no new contributions to his account thereafter. Based on the S&P 500 Index, by the end of 2002, his account would have lost almost 40%. Though the market rose over 60% in the next five years (2003 through 2007), the retiree would not have recouped those early losses until 2006 even if he had not taken any withdrawals. When we factor in withdrawals -- at the rate of 5% per year, for example, which locks in the losses – recoupment of the losses would be nearly impossible. If you then factor in the 37% loss in 2008, the retiree would have only about 34% of his original savings.
Example 2: The individual retires in 2003, at the beginning of the rising market. Like the retiree in Example 1, he has no new contributions to his account thereafter. Even with 5% per year withdrawals, the account of this individual would have grown by roughly 53% by the end of 2007. That is, he would have more money than he started with, even though he was taking distributions. In 2008, this retiree would experience the same 37% loss as the retiree in Example 1, but he would still have over 90% of his original savings.
If the retirees in both examples had been invested in a portfolio subject to less volatility, the market declines would not have had such a negative impact. The key, of course, is to create a portfolio that captures as much as possible the market returns while stabilizing portfolio volatility. We will discuss this issue and solutions for the risks facing retirees in future articles. For further details, see our White Paper, Creating Sustainable Retirement Income in 401(k) Plans Using Managed Risk Funds, at www.milliman.com/new401k.