Changing Risks in Retirement

Pair of scales is made of stones on the cliff

Retirement is a significant life transition that marks a shift from accumulating wealth to managing it for income. While this might seem straightforward, it's essential to grasp the unique risks retirees face compared to those still in the workforce. These risks highlight why retirement income planning is distinct from traditional wealth management. In this article, we'll explore these challenges in more detail.

1. Reduced Earnings Capacity

One of the primary differences between retirement planning and traditional wealth management is that retirees have less flexibility to earn income through work. As people retire, their capacity to take on financial risks decreases. This is because the value of their human capital declines, leaving them with fewer options to counteract poor market returns. Before retirement, individuals could mitigate market downturns by saving more, delaying retirement, or taking on more investment risk. However, in retirement, returning to the workforce can be challenging, and retirees often need to rely on fixed budgets.

2. Visible Spending Constraint

Retirees face a significant shift in their approach to investments. Instead of saving and accumulating wealth, they must now create a reliable income stream from their existing assets. This shift places a constraint on their investment decisions, as they must focus on generating income while minimizing risk. Taking distributions from their investments exposes retirees to the ups and downs of market returns, making it harder to adjust spending in response to market fluctuations. Even if someone is comfortable with market volatility, their risk capacity is limited in retirement.

3. A New Objective: Sustaining Income

The traditional goal of wealth accumulation is to maximize returns, subject to risk tolerance. However, this changes in retirement. Investing during retirement is different from investing for retirement, as retirees worry less about maximizing risk-adjusted returns and more about ensuring that their assets can support their spending goals for the remainder of their lives. The focus shifts from seeking return premiums on risky assets to ensuring that assets can support spending goals for the rest of retirees' lives.

In this new retirement calculus, views about how to balance the trade-offs between upside potential and downside protection can change. Retirees might find that the risks associated with seeking return premiums on risky assets loom larger than before, and they might be prepared to sacrifice more potential upside growth to protect against the downside risks of being unable to meet spending objectives.

4. The Impact of Sequence-of-Returns Risk

Retirement introduces a new dimension to investing: the need to sustain income from a portfolio. This differs from wealth maximization approaches that focus on portfolio diversification and modern portfolio theory. In retirement, the order in which market returns occur becomes crucial. Early losses in a retirement portfolio can force retirees to withdraw a larger percentage of their remaining assets to maintain their income. This can create a hole that's challenging to escape, even if markets eventually recover. The sustainable withdrawal rate from a retirement portfolio can fall below the average return earned by the portfolio during retirement.

Poor market returns early in retirement can significantly impact retirees' financial security. While the average market return over a long period may be favorable, negative returns in the initial stages of retirement can deplete wealth rapidly. This makes it crucial to consider the market conditions near your retirement date. Retiring during a bear market can be especially risky, as it reduces the resources available for future market recoveries.

5. Sequence Risk and Economic Outcomes

Sequence risk highlights the importance of the economic environment during the first years of retirement. A prolonged recession in this period, without an accompanying economic catastrophe, can put certain groups of retirees at a severe disadvantage. Some retirees might experience significantly worse outcomes than those who retire a few years earlier or later. Unfortunately, predicting such instances is challenging, as they may not be preceded by economic turmoil on a broader scale.

In conclusion, retirement income planning differs significantly from traditional wealth management due to the unique risks retirees face. Understanding these risks and taking steps to mitigate them is crucial for ensuring a financially secure and enjoyable retirement. Whether you're approaching retirement or helping a loved one plan for it, being aware of these challenges can make a significant difference in your financial well-being during retirement.

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