During the Q&A session of the recent June market update, I answered an open-ended question on fixed income. Part of my answer centered around the distribution challenge that advisors and retirees are facing today. Due to the complexities and nuances of this topic, I am going to break this up into a three-part series.
Today, my goal is to set the stage for the challenge that retirees are facing in the distribution phase. Part two will then take a deeper dive into some of the risks pertaining specifically to distribution and shed some light on the dangers of how some advisors are setting expectations for income in retirement. Finally, part three will present an alternative way to approach the challenge of income distribution compared to the prevailing strategies used by many advisors and investors currently.
When most people think about investing and their personal financial plan, they tend to view it as a fairly linear progression. They take a snap shot of where they are today, financially speaking, and project what their goals are 20-30 years down the road. Some investors will break that path up into two distinct phases – the accumulation phase and the distribution phase. Regardless if they view their financial life as one long continuum or two distinct phases, most investors assume that the risks in investing remain constant and similar no matter where they are on the path.
Our approach to investing is quite different. We view investing more like a mountain trek that has three distinct phases, each with its own unique challenges and risks – Ascent (Accumulation), Acclimate (Risk Mitigation), and Descent (Distribution).
During the Ascent phase, the investor is accumulating assets during their earning years. The primary risk inherent in this phase is volatility. Volatility in and of itself is not a bad thing despite what media often portrays. In fact, without a certain level of volatility it would be impossible to earn more than the risk-free rate that cash or treasuries are paying over the long term. The key is to appropriately gauge the investor’s appetite and ability to handle volatility and mirror that same level of risk within their portfolio.
Once the investor nears retirement, they enter the Acclimate phase. The primary risk at this point during the investor trek is loss. This is not to be confused with volatility. Absolute loss, or drawdown, at this stage can have a permanent negative effect on an investor’s financial goals. One reason is that they are much closer to the point in time that they will begin to take distributions from their accumulated assets to live on during retirement. Related to that issue, negative investor behavior (i.e. panic selling after losses) becomes more acute.
The final phase of the trek is the Descent, otherwise known as the distribution phase where investors begin to convert their accumulated assets into a replacement paycheck after they stop working. This is the phase that I will focus on for the remainder of this blog post and the two follow-up posts. The primary risk that investors face here is longevity – at its core, this is the risk of running out of money.
Before I move on, our friends at Horizon Investments recently issued a whitepaper detailing this redefinition of risk based on the investor stage. I would encourage you to check that out if you are interested in more information on the rationale for this investment philosophy. Here is a visual of what we’ve discussed so far:
Longevity as a risk can be a bit abstract to think about. I find it easier to grasp when breaking it down into the two core risk components:
- Sequence of returns risk – experiencing early losses in the distribution phase increases the probability of running out of money due to liquidating assets that are down in value, thereby locking in those losses permanently.
- Inflation – the loss of purchasing power over time.
The difficulty here is that these are competing risks. On the one hand, you need conservative assets within your portfolio to mitigate sequence of returns risk. On the other, equities are a better hedge against inflation than fixed income over time.
Hopefully that clarifies for you the unique challenge that investors are facing in retirement. Over the course of the next couple weeks I will shed some light on how advisors are attempting to solve this distribution riddle and also present a viable alternative.