Never before have so many people retired so early, lived so long, and have been so completely on their own managing their retirement resources.
Today, without pension plans as part of many retirees’ income resource pool more reliance is now placed upon the investment portfolio to help meet retirement cost of living needs. This shift brings a transfer of responsibility and risk for retirement from large corporations and pension plans to the individual investor and his/her investment portfolio.
Historically, retiree income resources included a pension plan along with Social Security benefits covering the majority of the household income needs leaving a smaller role for the investment portfolio. Today, typical retiree income resources consist of Social Security benefits and an investment portfolio.
The change in the retirement resource profile means more risk is assumed by the retiree from a heavier reliance on the investment portfolio to meet cost of living needs; a resource with more variability and unpredictability. Retirees need a sustainable income for life and today a greater share of their income resources now bring more risks to manage.
For instance, taking withdrawals from the portfolio when the market value of the investments reflect a loss increases the risk they may outlive their asset pool with much higher withdrawals taken during retirement than may be sustainable for the long term.
Secondly, the risk of the portfolio falling short of needed returns in the long run to meet annual cost of living withdrawals also means the investor assumes more longevity risk.
Although we know based on history what long run average investment returns might be for a given portfolio strategy what we do not know is the variation in the distribution of returns we might see going forward. For example; if the historical average rate of return for a given investment portfolio strategy has been 8% (1926 to 2013), going forward we may see returns of -25% for 1 year, 0% for first 10 years, and 10% for the next 10 years depending on market cycles. In addition, there are no guarantees past performance for a given portfolio strategy will be an indicator of future results.
Uncertainty and variability in the distribution of investment returns for the retirement period increases the risk of falling short of expected or targeted investment portfolio rates of return needed to continue to meet annual portfolio withdrawals through retirement.
Retiree’s assuming the greatest amount of risk from uncertainty and variability in the distribution of investment returns and stock market volatility typically have a heavy reliance upon the portfolio to meet a greater portion of their cost of living needs and the portfolio is a smaller resource pool. A smaller resource pool means less flexibility and room for error in meeting targeted investment returns and with timing of withdrawal decisions.
Timing of retirement and the length of the retirement period also play a role in risk assumption for the retiree. The younger the retiree, the longer the retirement period and the earlier investment portfolio withdrawals are likely to begin. The earlier portfolio withdrawals begin for retiree’s heavily reliant upon their portfolio to meet cost of living needs, the greater the stress on the portfolio to continually meet withdrawal needs.
Retiree’s heavily reliant upon their investment portfolio need certainty of investment returns and withdrawals to meet cost of living needs. This is difficult to manage when the primary resource, the investment portfolio, is variable and unpredictable.
Setting into place an investment structure to enable the investment portfolio to respond to short term cash withdrawal needs will help to build in flexibility and liquidity to minimize the effects of short term market volatility and timing of withdrawal decisions.
However, uncertainty in the distribution of returns where a retiree is heavily reliant upon his/her investment portfolio to meet cost of living needs may also call for additional diversification of retirement income resources which might include annuities or account guarantees on a portion of the portfolio. The addition of an annuity or account guarantee to the retiree income resources shifts the risks for uncertainty in the distribution of returns and market volatility away from the individual back to large corporations.
Retirees with a larger investment portfolio who require less from their investment portfolio to help meet annual cost of living needs have more flexibility to manage through the variation in distribution of returns and cycles of market declines with less need for further diversification of retirement income resources.
There is no one right answer for the amount and type of diversification within a typical retiree’s income resource profile. Each individual retirement situation is unique and always requires careful planning to determine the appropriate level of diversification of retiree income resources.