Nobel Prize-winning economist Bill Sharpe famously described the decumulation of assets in retirement as the “nastiest, hardest problem in finance”. Whilst accumulating wealth largely depends on a few straightforward factors, how much you save and the length of your investment timeframe, managing drawdowns in retirement is far more complex and uncertain.
The risks related to asset decumulation in retirement are relatively new. During the era of defined benefit schemes, the responsibility for providing income in retirement rested with employers or scheme providers. However, with the shift to defined-contribution (or accumulation-based) models, individuals now shoulder these risks themselves.
This article will be an introduction into the risks with the drawdown of assets in retirement. It will form the basis of future articles that review the different strategies that can be employed to create a more secure and sustainable retirement.
The Risks of Retirement
Retirement brings with it a range of risks that many individuals have not encountered before, beginning even in the years leading up to retirement.
Longevity Risk
Longevity risk, the risk of outliving your capital, is perhaps the easiest to understand. With life expectancies steadily increasing, this is a concern every retiree must account for.
Relying on average life expectancy to plan your retirement is like flipping a coin: 50% of people live longer than the average. A seemingly logical solution is to adopt conservative drawdowns, preserving more capital for later years. However, this strategy comes at the cost of potentially reducing your quality of life in the earlier years of retirement. Statistically, this approach has its own 50% risk: dying before life expectancy with unspent money that could have been used to enhance your earlier years.
Guaranteed annuities and similar products aim to address longevity risk, but they often require giving up current flexibility for the assurance of financial stability in later years. While they offer peace of mind, these products are far from perfect and may not suit everyone.
Sequencing of Returns Risk
Sequencing of returns risk arises when poor investment returns occur during the most critical phase of retirement, typically the five to ten years before and after retirement begins. These negative returns disproportionately impact a portfolio. We have already covered this in detail.
The higher the volatility of the assets in the retirement portfolio, the more pronounced this risk is. Therefore, the natural answer to sequencing risk is to reduce the exposure to growth assets like shares in favour of more defensive assets like cash or bonds.
Whilst likely reducing any sequencing risk, this strategy likely increases longevity risk in turn. Lower returns from defensive assets may mean using more of your capital to fund expenses, potentially leading to premature depletion of funds.
This trade-off highlights the difficulty of addressing sequencing risk: the volatility needed for higher returns also introduces uncertainty, making it challenging to develop a retirement plan that balances competing risks.
Inflation Risk
Any good retirement plan must account for inflation. For example, maintaining a $50,000 annual lifestyle will require significantly more money at age 90 than at age 60. Many plans address this by applying an average inflation rate, such as 3%, to withdrawal projections.
Whilst better than nothing, it does not account for the idea that inflation also has a sequencing risk component to it. Despite inflation generally being more stable than investment returns, it can still vary considerably year over year.
High inflation can also coincide with poor investment returns, compounding its negative effect on a retiree drawing down on their assets. Take 2022, for example; it was a year of inflation in the 6%, and every major asset class returned a negative return aside from cash.
For an Australian retiree in 2022, their purchasing power will have reduced by 6% with no investment return making up for it. They will have to draw more of their money down in that year, potentially selling assets at a loss to do so.
Unlike most investment losses, inflation doesn’t reverse over time. A year of high inflation permanently erodes purchasing power, making adequate preparation essential to avoid its long-term effects on a retirement plan.
Market Risk
Market risk refers to the possibility that investment returns fall short of what’s needed to sustain your intended lifestyle. While similar to sequencing risk, market risk encompasses the broader challenge of portfolio volatility and inadequate returns.
For example, an investor expecting a 4-5% annual return from Australian Government Bonds may have been disappointed by the past decade’s average of just 1.72% p.a. Market risk can be mitigated through diversification, but there will still be years, like 2022, when all major asset classes underperform.
Effectively managing market risk requires careful planning, realistic expectations, and diversification to ensure the portfolio aligns with long-term retirement goals.
Summary
There is no simple solution to the challenge of asset drawdown in retirement. While strategies exist to mitigate the associated risks, they should be carefully tailored to each individual’s circumstances as they don’t necessarily suit everybody.
The shift from defined benefit schemes to account-based accumulation super funds has transferred the four key risks directly to retirees. Unfortunately, these risks are often poorly understood, leading to suboptimal outcomes for both retirees and society as a whole.
Recent research has shown that the simple fear of running out of money early prompts retirees to underspend and thus leave large amounts of money in super as an inheritance. This behaviour conflicts with the intended purpose of the superannuation system, which is to provide tax advantages to fund purely fund a member’s retirement.
This also has another negative impact on the retiree themselves. Every dollar left in superannuation at death reflects a missed opportunity to enhance quality of life during retirement. This is a loss of opportunity that was directly borne from the fear of running out of money prematurely.
Future articles will explore popular strategies designed to address these risks, focusing on maximising retirees’ quality of life while prioritising financial sustainability.
