Risks to Retirement
During the accumulation phase of a retirement portfolio most investors focus on managing volatility with the goal of achieving long-term growth. However, during the distribution phase of a retirement portfolio income longevity is the goal and volatility has a uniquely different affect on performance. Ultimately, the goals, investment rules, and risks for a distribution portfolio are different than for an accumulation portfolio. This is why the management of distribution and pre-retirement portfolios require an entirely new professional skill set and expertise.
There are three significant financial risk factors for a retiree:
Longevity Risk: Longevity risk means living "too long" or longer than a persons resources can financially support.
Investment Risk: Investment risk quantifies the probability of portfolio depletion.
Inflation Risk: Inflation risk refers to the ability to maintain purchasing power.
The advanced retirement planning methodology is based on a retirement plan's ability to withstand the three risk of retirement; investment risk, inflation risk, and longevity risk.
For distribution portfolios market risk has two components, reverse dollar cost averaging (RDCA), and the longer term trends of the stock market. Investment risk and inflation risk combined is called the "Time Value of Fluctuations". It represents a permanent loss that is unique to distribution portfolios.
TIME VALUE OF FLUCTUATIONS (TVF)
The “Time Value of Fluctuations” only affect distribution portfolios and accumulation portfolios that are in the pre-retirement phase. The "Time Value of Fluctuations" is composed of three risks:
Sequence of Returns: At the early stages of retirement, will the stock market experience a long-term upward, sideways, or downward trend? Long-term trends are called “secular trends” and last anywhere from 8 to 20 years. The order and magnitude of returns have a significant impact on the success of retirement portfolios.
Inflation Risk: Over time, it costs more to live and therefore, it is necessary to increase withdrawals to keep up with living expenses.
Reverse Dollar Cost Averaging (RDCA): Reverse dollar cost averaging is the process by which investments are sold periodically to provide an income. During low markets more shares/units must be sold to maintain the same income flow. Even though markets may eventually recover, the loss is permanent because the shares/units that were sold are no longer in the portfolio and cannot participate in the recovery. On average RDCA can reduce the portfolio life by approximately 15%. Reverse dollar cost averaging does not affect accumulation portfolios (even during the pre-retirement phase).
Since the risk of the “Time Value of Fluctuations” is outside of everyone’s control, it is often referred to as “The Luck Factor”. In many cases, the actual portfolio life that is forecast by a traditional retirement calculator will be cut in half, due to the negative affects of the “Time Value of Fluctuations.”
Aside from the withdrawal rate, the luck of “retirement timing” is the largest determinant of retirement success. Advanced retirement planning calculates the possibility for lucky, average, and unlucky outcomes.
However, advanced techniques demand that we plan for unlucky outcomes. This is why:
When an engineer builds a skyscraper, s/he does not build it to withstand the average wind velocity. The engineer designs the building to withstand the strongest wind velocity. Otherwise, an above average wind could bring down the building.
However, most retirement planners and retirement planning software programs use the average return. If the retiree’s portfolio experiences anything less than average, their plan will fail. This is not a failure of the retiree, but a failure of faulty methods and assumptions.