Many retirees and retirement planners are heavily invested in spending rules, such as the commonly known and touted ‘4% rule’, which is used to determine how much a retiree should withdraw from their retirement savings. While such spending rules can assist in attempting to protect us from outliving our savings, they certainly don’t promise to do so.
What we can do though is construct an informed strategy, that takes a good swing at ensuring that a retiree can outlive their savings. To construct such a portfolio, a multitude of factors must be considered. Two such factors are longevity risk and sequence risk.
A lot of thought goes into deciding on a time at which to retire. Thinking about how long your retirement will last, however, doesn’t quite attract the same amount of attention. This matters a great deal because it determines how long your retirement will be, and, therefore, how long your money needs to last for.
For example, if you retire at 60 and live to 90 your money needs to last 30 years. If you were to retire at the same age, but die at 70, then it only needs to cover 10 years. The amount of savings needed for those two scenarios are entirely different. Admittedly, contemplating your own death, isn’t the most inspiring of topics, but it obviously matters when thinking about retirement.
Life expectancy is usually based on your age, gender, race, health, lifestyle, occupation and family history. But remember, these are just estimates. There’s no way to predict how long you’ll actually live but with life expectancies on the rise, it’s probably best to assume you’ll live longer than expected. Indeed, if we continue to improve how we treat major killers such as cancer and heart disease, that life expectancy could very well move even higher.
As people live longer, the risk of running out of money during retirement becomes heightened.
Sequence risk, or sequence of returns risk, is the risk that the stock market crashes early on in your retirement. Why does this matter, you may ask?
It turns out that for retirees, long-term average returns (average portfolio growth) matter less than when those returns occur. If a portfolio has a decade or so of positive gains, it reaches a critical mass where it can withstand simultaneous losses from withdrawals and price dips.
However, when you’re only selling stocks and not buying them, a crash is all downside; your portfolio drops dramatically in value and you end up selling low without the ability to gain by buying low. You will also need to sell more of your stocks to generate the same amount of income, which means you’re selling off your nest egg shares at a faster rate.
Most experts advise their clients to plan for a 30-year retirement period. This is obviously quite a long time. Long enough that we can be confident a retiree will see the full array of market returns over time, and their average will converge to the long-term market average.
When it comes to guarding against an unfortunate sequence of returns, let’s remember that the 4% rule was designed to incorporate the very worst retirement periods in history. Even if a retiree is extremely unlucky and sees their worst returns earlier on, the 4% rule should still work.
Over a 30-year retirement period, it’s almost certain that you’ll see a few market calamities. There’s not much you can do about that. Nor can you do much about the timing of those calamities. Sticking to the 4% withdrawal rule gives you a very high probability of never running out of money. A high probability but no guarantee.
Start investing early, save regularly and consult with an investment manager for professional advice. Do as much as you can to stack the odds in your favour. Investing after all is not a game of guarantees but rather one of probabilities. We’re yet to meet a client who regrets having too high an income to spend post-retirement. Spending rules attempt to protect us from outliving our savings but make no promise to do so when the time comes.
Mduduzi Luthuli is the director of Luthuli Capital.