Spending Assumptions Throughout Retirement

“Our findings suggest that typical consumption in retirement does not follow a U-shaped path –consumption does not dramatically rise at the start of retirement or pick up towards the end of life to meet long-term care related expenditures.” - Dr Brancati, International Longevity Centre.

Consumption in retirement starts relatively high and ends low. This pattern is common to both highand low-income groups, is robust to the inclusion of factors other than age and is not simply the result of the time period in which the data was collected.

Of course, many people will need care in later life, but this is not typical. Consider the following6:

• only 16% of people aged 85+ in the UK live in care homes

• the median period from admission to the care home to death is 462 days. (15 months)

• around 27% of people lived in care homes for more than three years, and

• people had a 55% chance of living for the first year after admission, which increased to nearly 70% for the second year before falling back over subsequent years

Sequence of Returns Risk

It’s well understood that the returns from capital markets can be volatile and unpredictable in nature. Sequence risk is the order in which these returns arrive to a portfolio. It’s amplified during the retirement phase due to the addition of systematic withdrawals alongside investment volatility.

The sequence of returns experienced early in retirement can have a disproportionate impact on the outcome experienced by the client and results in a much wider range of potential outcomes during the retirement phase. Helping a client to navigate this risk is a significant challenge.

The charts below show the outcomes experienced by two different portfolios which achieve the same five percent average return over a 30-year period.

When clients are accumulating wealth, the order in which returns arrive to the portfolio doesn’t alter the final outcome.

When decumulating wealth however, the order in which returns arrive to the portfolio is critical to the outcome experienced by the client, as the withdrawals in poor market conditions crystalise losses, making it more difficult for the portfolio to subsequently recover.

The decumulation example uses the same portfolios as in the accumulation example but this time includes a withdrawal of four percent per annum. This illustrates how the sequence of returns can significantly impact the outcome experienced even if the average return assumption is achieved.

To reduce the impact of sequence risk a lower return assumption can be used within the retirement plan. This improves the probability of the portfolio achieving the return required to make the plan a success, especially early in retirement when sequence risk is heightened. Managing sequence risk in this way increases the cost of funding a client’s retirement objectives, especially when combined with a longer planning horizon to mitigate longevity risk.

Managing Sequence of Returns Risk

The sequence of returns in the markets is something we have no control over. Some investors are blessed with weak returns in the accumulation phase and strong returns when they have more money while others are cursed with brutal bear markets at the outset of retirement or markets that go nowhere when they have a bigger balance.

Luck plays a larger role in investment success than most realise since we each only have one lifetime (our own) in which these things play out for us personally.

We have no control over the sequence of returns in the markets but here are some ways to manage this risk:

1. Be flexible. The best part about simulations is they force you to be disciplined (this is also why they’re so difficult to follow in real time). The worst part is they offer little flexibility. Being flexible in terms of spending rates, saving rates, the timing of cash flows and how you treat the spoils of bull markets and pain of bear markets can make a huge difference. You can always adjust these levers depending on how the real world differs from your original projections. A steady savings rate, withdrawal rate or asset allocation may look good in a spreadsheet but will likely have to be adjusted based on how things play out.

2. Be conservative. The best way to give yourself a margin of safety is to set realistic return expectations, inflation projections and how you spend and save your money. A high savings rate means more money when you come to retire and eventually spend down your portfolio. High inflation expectations give you room for error in your personal inflation rate. Not overdoing your spending when market returns are high can help avoid having to cut back when they’re low.

3. Don’t become a forced seller. Sequence of return risk can be painful if you’re on the wrong end of it, but it becomes a double whammy if you end up being a forced seller of stocks when they’re down. This can be avoided through portfolio design, diversification, and intelligent deployment of cash flows. Building up reserves when things are going well to survive when things are going poorly can help.

4. Manage volatility. Volatility is not equal to risk when investing but it can be a tax on your results if you don’t handle it correctly. Reducing portfolio volatility, in at least a portion of your portfolio, is a wise move to be able to survive any major disruptions in the markets, the economy or your personal life. This also includes how you manage the volatility of your emotions when markets are going up or down.

5. Know your place. Managing risk differs depending on where you are in your investment lifecycle. Those just starting out with little in savings are going to have a completely different risk profile and time horizon than those in retirement who need to live off their life savings. Withdrawals from your portfolio are an entirely different animal than building one through periodic savings. Risk matters to some degree when you’re young but not much. Risk really matters when you no longer have human capital and are planning to live off your investment earnings for the remainder of your days.