Guided Retirement Income Planning- Chapter 13

As you prepare for retirement, it is important to design a plan that is built to last. You want to enjoy life and have enough confidence that you can meet your goals. A customized plan will help avoid portfolio failure. We are being intentionally repetitive about emphasizing the repercussions in not planning properly for longevity; failing to plan can be traumatic later in life. It is easy to lose track of decisions you do or do not make and how they can impact your future. Understandably, you do not wake up each day with the intention of depleting your assets sooner than later, causing portfolio failure. Yet, this can happen. Here are important risk management concepts and considerations to help mitigate portfolio failure.

Definition

Portfolio failure – There are two standard, negative outcomes that periodically need to be assessed:

• The probability of failure – That means outliving your assets.
• The magnitude (size) of failure – This represents the gap between minimum guaranteed income sources and minimum spending needs after assets have been depleted.² 

Let us take a moment to review factors that may contribute to portfolio failure and approaches that may help reduce this risk:

Structural

Risk tolerance – A measurement of how much market volatility and investment variability that you are willing to accept and live with. Risk tolerance is dependent on a combination of criteria such as age, income, net worth, financial goals, and most importantly, your comfort level. As financial advisors, we use a combination of risk tolerance questionnaires, software programs, and general discussions to help define your risk tolerance. By having too little or too much risk in a portfolio, people are more apt to make inconsistent market timing decisions based upon emotions, fraught with behavioral biases. It is therefore very important to get your risk tolerance right and to periodically revisit it over time.

Risk capacity – The amount of risk your portfolio should take on to achieve your goals. Often mistaken, risk tolerance and risk capacity are similar but not the same. Misunderstanding these factors may result in a disconnection between your plan’s asset allocation and outcomes. While risk capacity is the ability for your portfolio to take on risk, risk tolerance is your desire, or lack thereof, to take on risk for higher performance potential. These assessments can differ dramatically. For example, in retirement, market-related losses will have a significantly greater impact on the long-term success of your plan. You may measure as having a high risk tolerance but your risk capacity for taking on higher levels of portfolio volatility may be constrained due to limited assets, use of assets, or other circumstances. Sophisticated software is available to conduct stress tests and to balance required and desired risks for performance throughout retirement.

Environmental

Black swan events – Rare, negative events or occurrences that are extremely difficult, if not impossible, to predict. Recent examples include the 9/11 attacks, the Great Recession of 2008, and the Covid-19 Pandemic in 2020. These events result in severe, short-term damage to the economy, public fear, and extreme market volatility. Although these events are rare, we have experienced three of them in under a twenty-year time frame. This leads us to ask, will these black swan events continue to occur with the same frequency going forward? If you believe so, your retirement income plan should be designed to overcome the consequences of such an event.

Behavioral

Hindsight bias – In Chapter 3, we defined this behavior while alluding to black swans. This behavioral challenge is when people believe afterward that events were or should have been more predictable. The metaphor of driving while looking through a rear-view mirror comes to mind! Black swan events, particularly, along with hindsight bias may conjure poor decision-making and lead to frustration, anger, regret, and depression. If you think you are experiencing these emotions, be careful to not confuse what is understood in retrospect with very abnormal and almost impossible to anticipate circumstances before they occur.

Utility (happiness) theory – This is a core concept in behavioral finance. The idea is that as you spend more, your satisfaction from the additional spending increases but at a declining rate. Another way of saying this is as your spending increases and your portfolio decreases over time, your level of happiness may decline as well. For obvious reasons, you should beware of this behavior and the potential impact on your portfolio.

Financial

Underfunded retirement plans – The goal of every plan is for a successful long-term outcome. The factors and approaches that help minimize the risk of portfolio failure can contribute to your retirement plan being sufficiently funded or underfunded. If a retiree’s portfolio is seriously underfunded, there are only limited corrective actions, all of which can be difficult to implement:

• Spend less (best option for many)
  
  
• Invest more aggressively (adds more upside potential and more risk)
  
  
• Seek to lower portfolio volatility (stops the bleeding but does not solve the long-term problem)
  
  
• Reduce remaining life span of the plan (obviously not a good choice)
  
  
• Go back to work full or part-time to fill the income gap (this choice may not be available to many)
  
  
• Utilize home equity, if available (to be discussed in chapter 20)

Spending assets down to go on Medicaid – You may be considering the value of your accumulated assets and income sources and whether they will be enough to meet your needs. If you “spend down your assets,” you may feel going on Medicaid is an option. However, this is generally NOT a desired outcome since you lose financial independence and government laws and regulations will dictate your lifestyle.

It is important to review your retirement income plan regularly. If you plan, there are almost always strategies to help mitigate portfolio failure. The best outcomes from a retirement income plan are identifying and helping mitigate risk factors (Ch. 10) while supporting the achievement of your legacy goals.