Risk Versus Risk

24 Aug

Risk Versus Risk

The average investor is probably familiar with the term investment risk. What the average investor is probably not familiar with is the types of investment risks that exist. Risks faced in retirement are markedly different than those faced during accumulation years. The types of investment risks are: interest rate risk, business risk, credit risk, tax-ability risk, call risk, inflationary risk, liquidity risk, market risk, reinvestment risk, political or social risk and currency risk. Most of those terms may not mean much to the average investor, but they are very important to be cognizant of not only during the accumulation phase, but also during the distribution phase (retirement). So we’ve identified the general basic risks that the average investor will face, but there’s another frontier of risk to explore that many rarely consider. The investment risks stated above do not go away during the distribution phase (retirement), but a few other risks come into play. One of the risks is withdrawal rate risk, which I wrote about in this post. Withdrawal rate risk works hand in hand with the other two risks, which are longevity risk and sequence of return risk. As stated in the article regarding withdrawal rates in retirement, the old 4% rule may not be a viable strategy going forward, unless you can mitigate the risks of longevity and/or sequence of returns.

As the calendar turned to January of 2011, the oldest batch of the Baby Boom generation turned 65. That day, and every day since, approximately 10,000 boomers have turned 65. The Pew Research Center states that this trend until 2030, which is when 18% of the nation will be at least 65. Why is this important? Well not only has life expectancy risen, but it’s rising while a massive generation reaches retirement age and puts an unprecedented strain on the government for Social Security and Medicare. This isn’t to start a debate about those programs, it’s simply a fact. As we live longer and a large group of individuals turns 65 in a small time frame, our focus needs to shift towards thinking about retirement through a new lens. As I wrote in that article, fundamentals alone are shifting, which doesn’t even account for longevity risk. Read that article and then introduce potentially living longer to the equation. Simply put, your retirement savings not only need to support a likely higher withdrawal rate, but they also need to last longer.

Sequence of return risk is simply the risk of receiving lower or negative returns early in a period when withdrawals are being made from an individual’s investments. The order, or sequence, of investment returns is the most overlooked of the three risks. Most investors focus on the average rate of return needed to sustain their lifestyle in retirement, but that can be devastating once you’re out of the accumulation phase. I’ve inserted a basic chart that I created to illustrate the impact, with the following criteria: 5% annual return, positive sequence of 15%, 7%, 3% -5%, negative sequence of -5%, 3%, 7%, 15%. The portfolio starts with $1,000,000 and assumes a 5% annual withdrawal, with a 3% increase each year for inflation.

The blue line represents a portfolio with a 5% rate of return each year. The orange line depicts a positive sequence of returns and the gray line represents a negative sequence. All three scenarios are an average return of 5%, but look at the impact of the sequence. This is how it’s easy for investors to not worry about sequence when in the accumulation phase, as three basic scenarios listed above all wind up with a 5% average rate of return, yet the picture is so much different based on how you arrived at that 5% average. This basic exercise underscores the importance of having a well thought out financial plan BEFORE  you reach the distribution phase of your life. When you factor in withdrawal rate risk as well as longevity risk, you can see how important mitigating sequence of returns risk as well.

Some 50% of the population in the U.S. are likely to live past their average mortality rate, and if you don’t properly address all three of these risks, one can run the risk of outliving their retirement funds. There are many ways to mitigate these risks, and the time is now to address these issues.

 

Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.

Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.