You’ve worked hard your whole life, saving along the way for retirement. You’re finally ready to transition to a new lifestyle of relaxation and enjoying the things you’ve long dreamt of but never had the time for: traveling, reconnecting with old friends and spending more time with the grandkids, to name a few.
But, how feasible is your dream retirement if your portfolio faces a market decline, or if your retirement extends beyond expectations? Fortunately, there are strategies available to help you prepare for these uncertainties.
Understanding the potential risks can help you plan to minimize them.
What Are The Potential Risks?
1. Sequence-Of-Returns Risk
As you approach retirement, your portfolio becomes more susceptible and vulnerable to adverse market conditions because you may have limited time to recover. This describes one of the greatest risks for retirees: sequence-of-returns risk. It is the risk of experiencing poor market performance right before or early in retirement, when your portfolio is likely to be its largest.
“A bad sequence of returns in your portfolio during this critical period may force you into having to spend less to avoid depleting your nest egg too quickly,” explains Joe Toledano, Managing Director, Head of Insured Solutions, Morgan Stanley Wealth Management. Here’s one such scenario: Let’s say a new retiree with a $1 million portfolio plans to withdraw 4%, or $40,000, in her first year of retirement. If a market downturn causes her portfolio to suddenly decline 30% to a value of $700,000, that original $40,000 withdrawal now accounts for 5.7% of the portfolio’s value. Such a higher withdrawal rate may not be sustainable long term without a rapid recovery in her portfolio’s value. What’s more, withdrawing funds during this hypothetical bear market lowers her portfolio’s base of assets, increasing the returns that would be required for it to recover.
2. Longevity Risk
Outliving one’s savings is a growing concern as medical advancement and economic development contribute to longer lifespans.1
Consider the retiree who, at age 65, has a $1 million portfolio with 60% in stocks and 40% in bonds. Based on Morgan Stanley Wealth Management’s capital market assumptions, she would have a high, likelihood (93%) of being able to sustain 5% withdrawals from her initial portfolio each year, indexed to inflation, if she lives to the average life expectancy of 85.2 However, if she were to live another five years, the likelihood of being able to keep up that income level falls to 74%, exposing her to material risk of running out of money.2
What’s more, if she enters retirement a bit less prepared and therefore has to spend 6% of her portfolio in her first year, her probability of making it through retirement without exhausting her savings drops from a less-than-ideal 70%, to a likely unacceptable 41%.2 The fear of running out of money in retirement may drive some retirees to under-spend relative to what they can afford, sacrificing their standard of living. It’s little surprise then that 45% of retirees report their expenses in retirement are higher than expected, and most (62%) are unsure how long their savings will last.3
How Can Retirees Help Minimize These Risks?
Fortunately, there are ways to help you prepare for these unknowns.
1. Bonds May Provide Balance
Integrating bonds into a retirement plan can help balance a portfolio by reducing volatility and providing a predictable income source. This is especially beneficial in the early years of retirement when sequence-of-returns risk is high.
However, bonds can introduce interest rate risks—the possibility that if market interest rates rise, existing bond prices fall, potentially leading to losses in a portfolio. This risk needs to be managed within a retirement strategy.
“Traditionally, bonds provided some sense of security, but even with interest rates near their highest levels in two decades, they still may not be enough to support the income clients need to cover expenses in retirement,” says Carmine Mazzeo, Executive Director, Insured Solutions, Morgan Stanley Wealth Management.
2. Annuities Can Add Income Stability
Annuities can also play an important role in a retirement strategy. For one, they can help to mitigate sequence risk by providing a reliable source of income that can reduce—and, in some cases, may even help reduce the need to sell portfolio assets with high return potential at a moment when asset prices have fallen precipitously.
Additionally, annuities may provide guaranteed income benefits provide a set level of income for the rest of your life, much like a traditional pension in that respect. By adding such annuities to your portfolio, you may potentially reduce the risks that poor judgment, declining markets or a longer life expectancy that may jeopardize your ability to live comfortably in retirement.
In fact, a 10-year hypothetical analysis by Morgan Stanley’s Global Investment Office found that annuity allocations in a portfolio enhanced outcomes for savers in a remarkable 97% of cases, relative to strategies using only traditional investments with the same level of risk.2 The hypothetical portfolios with annuity allocations delivered:
- 19% higher probability of sustaining income throughout retirement, on average2
- 10.1%-11.8% higher wealth after sustaining 30 years of withdrawals2
Another potential benefit of annuities: Unlike with traditional investments, the earnings and interest associated with an annuity are not subject to taxation until paid out, even when they are held within a taxable investment account.
“Annuities are a tool that, when used intelligently, holds significant potential to improve an investor’s quality of life in retirement,” notes Dan Hunt, Morgan Stanley Wealth Management Senior Investment Strategist. “They may help reduce risk in a retirement plan because in some cases their payout rates may be higher than yields available from certain traditional income investments, depending on product features and market conditions."