Rethinking risk in retirement planning
Since 1928, there have been five rapid US stock market crashes of 30% or more:
- Crash of 1929: -39% (October-November 1929).
- Great Depression: -34% (September-October 1931).
- 1987 crash: -31% (October 1987).
- Great Recession: -31% (September-October 2008).
- COVID-19 pandemic: -33% (February-March 2020).
The graph below shows how portfolio balances would have evolved for hypothetical couples who retired six months before these crashes. These couples followed the well-known (though flawed) “4% rule” and withdrew $ 40,000 per year from a portfolio worth $ 1 million in retirement (all in adjusted dollars. inflation).
No couple has come close to running out of money. Their liabilities were small and spread out, so one major stock market crash (or even two) was not enough to derail retirement. Although not much time has passed since the two most recent crashes, evidence so far suggests that even the 2008 global financial crisis and the 2020 COVID crash did not destroy retirements.
Bend to avoid breaking
Unlike the case of the highly leveraged hedge fund, retirees can adjust the size and timing of many pension liabilities after a risk has arisen. People can cancel or postpone a vacation or change a date from dinner at a steakhouse to burgers at a brasserie. This flexibility would be like a hedge fund retroactively deleveraging its positions after a market drawdown: impossible for the hedge fund, but commonplace for a retiree.
Research shows that, historically, virtually any sound financial plan (where the initial income level leaves a buffer to absorb risk) could have been saved with relatively minor adjustments, even in the worst-case scenario of history. Take the example of a couple who retired in 1966, just before a prolonged period of high inflation and low real returns, with a portfolio worth $ 1 million in 2021 dollars.
Imagine that this couple started their retirement with $ 45,000 in portfolio withdrawals per year and a plan to adjust those withdrawals for inflation over time. This couple could have made a single reduction in nominal income (in 1975) as well as two less than full inflation adjustments (in 1980 and 1981) and stayed well away from ruin. They would have kept over $ 800,000 in the portfolio balance after 30 years (just under $ 200,000, adjusted for inflation).
Today’s static financial planning platforms, however, do not allow advisors to incorporate contingencies and adjustments into financial plans, and they certainly don’t simulate or demonstrate what retirement might look like if it included adjustments. Instead, clients typically see simulated static pension plan charts that show some portfolio balances going to zero.
Faced with a graph like this, it’s hard for customers not to think of financial ruin as a significant possibility. Because it does not reflect realistic adjustment behavior, this graph (incorrectly) suggests that retirement it is true like a hedge fund. Unfortunately, this feeling is hard to get over no matter how an advisor tries to reassure the client that “failure” simply means “adjustment.”
To help clients truly understand the risk in retirement, it is best to avoid the concept of failure and comparisons to plane crashes. Instead, clients benefit from understanding the factors that make retirement income so resilient: Spending needs are spread over time and some planned spending is flexible or optional.
Reframing the outdated discussion of retirement income risk from that of succeeding and failing at one of the (minor) adjustments will provide clients with a more realistic view of their retirement journey so that they can worry less and enjoy life more.
Justin Fitzpatrick is Co-Founder and Chief Innovation Officer of Income Lab.