By Christopher W. Beale, CFP®
My fundamental assumption about income is that there are only three sources. The first source of income is from our Labor; wages, salary, commissions, tips, royalties etc. We work, we're productive, we add value to society and we earn money from our labor. Money is used to either consume currently or to save for future consumption. The second source of income is income which comes from Capital or savings. If we don't create and save enough capital from our labors we are forced to use the third source of income which is friends, relatives or charity. Social Security and Medicare are savings, albeit forced savings through our tax system. Government programs such as Medicaid are instead a form of government charity.
So the retirement income goal is to build up enough capital to provide an income source which will replace our income from labor, thereby not having to rely on friends, relatives or charity. It sounds simple enough in theory, so where's the dilemma?
The dilemma comes from transitioning from labor income, which is typically more consistent (although anyone downsized in the Great Recession would disagree), to capital income which can be more variable. The purpose of this article is to identify certain risks associated with transitioning from labor income to capital income such as market risk, longevity risk, sequence of returns risk, purchasing power risk, and behavioral risk.
Market Risk is the risk of losses due to movements in market prices which occur daily and are inherent to all investors. Accounts subject to market risk are certainly a cause for concern when we attempt to take a steady distribution from a variable account. One solution to this problem is to vary the distributions when changes occur in market prices. I don’t think this a practical solution as most retirees could not live with such uncertainty in income and spending. A better solution would be to reduce volatility in investment accounts through proper diversification and asset allocation. Two simple examples are not having more than 10% of your assets in any one stock or bond or fund, and allocating among investments with low correlation, meaning one investment should zig when another zags. In our practice we have identified 19 distinct asset classes inside 4 broad categories. The 4 broad categories are: Stock, bonds, alternatives, and cash. Chris Lee did a wonderful job explaining how we manage money in our newsletter dated January 2014. We understand that reducing (please note that I did not say eliminating) market risk can add consistency to those clients receiving income from their accounts. We account for market risk when building our portfolios. We understand your account will fluctuate. Short term fluctuation is the admission price for long term returns that have historically been greater than returns from non-fluctuating investments.
Longevity Risk is the risk that we under estimate how long we will live, thereby outliving our capital. Based on the 2000 mortality tables the joint life expectancy of a 65 year old couple is 27.1 years. On average women live 6.5 years longer than men. Average life expectancy for women has increased 25 years from a century ago, from 56 years in 1914 to 81 in 2014. Of course I’ve always said average people don’t walk through our office doors. Our clients tend to be healthier, happier, wealthier, better educated and have access to better medical care including complementary or non-traditional medical care. These factors lead to longer life spans. How we manage your money and allocate your account is key to countering longevity risk. So too is our method and amounts of income distribution. I still believe a valid rule of thumb or starting point for retirement income distribution is the “4% rule”. 20 years ago Financial Planner, William Bengen studied historical returns over a typical retirement time frame and concluded a 4% withdrawal rate adjusted for inflation would be deemed safe in all 30 year timeframes since 1926. The body of research has been expanded and modified over the last 20 years by many academics and practitioners. Again, the much larger number of asset classes we use in our models increases diversification and reduces portfolio volatility.
Last month I had the pleasure of listening to and speaking with Dr. Wade Pfau, Professor of Retirement Income at The American College, at an industry conference in Dallas, TX. His research has appeared in such diverse publications as The Journal of Financial Planning, Money Magazine and the AARP Bulletin last month alone. His concern was “Sequence of Returns Risk” or starting retirement distributions when the market is overvalued. His presentation which should be published by the end of this year concluded that sequence of returns risk could be alleviated by decreasing distributions during times of poor market performance and increasing distributions during times of good market performance. Another solution he stated was to reduce portfolio volatility. Since the vast majority of our retired clients don’t want significant disruptions to their income, (or spending), we at New England Capital have attempted to reduce portfolio volatility through dynamic asset allocation and investment selection.
While annuities can be part of the solution, they are not without risk or cost. Fixed annuities eliminate market risk and longevity risk, but the income stream is subject to Purchasing Power Risk or inflation. Even the relatively benign 2.8% inflation rate (which Social Security now uses as their future inflation assumption) would cause a more than doubling of prices during retirement. Think of only buying half the food, buying half the medicine, or only being able to pay half your property taxes in retirement! Annuities also reduce terminal wealth, so if passing on an inheritance to your children or grandchildren is one of your goals, it would be reduced or eliminated by the use of annuities. Annuities certainly can reduce some risks by transferring that risk to insurance companies. Of course like all insurance, this risk transfer has costs which must be weighed against its benefits.
The last risk we work with daily is Behavioral Risk. Many investors are their own worst enemy by wanting to do the wrong thing at the wrong time. The Boston research firm Dalbar, Inc. shows that investors prefer to buy hot performing funds after they have gone up in price and sell after they’ve gone down in price. Over the last 20 years the average equity investor has made 5.0% annually while the stock market has averaged 9.2%. Watching one of my sons, Michael’s, high school soccer games made me think of soccer/investing analogy. A study showed that when an elite goalie is defending a penalty kick, they will leap to either side of the net 95% of the time when the ball is kicked in the middle 30% of the time. Why? Because even if they miss the ball, doing something feels better than doing nothing. That same feeling of needing to leap to do something has typically hindered investor’s long term success. To counter behavioral risk, we at New England Capital attempt to set appropriate expectations, control risk and reduce portfolio volatility relative to the overall market, and monitor risks in the portfolios continuously.
Emotions can be wonderful, and I wouldn’t want to live my life without emotions. In investing however, they could lead us to act in a way we wouldn’t act if we simply took time for thoughtful reasoning, and a thorough assessment of all options. After more than 31 years as an investments professional, I still need to keep my emotions in check with investment decisions I make on your behalf. Luckily, I must have been born with a counter intuitive gene, because my goal for you is to do the opposite of the average investor. I like to buy low and sell high, but only after thoughtful reasoning and a thorough assessment of all our options.