Strategies to reduce retirement income uncertainty amid market volatility

Glenn Freeman

By

August 21, 2015

KITCES_MichaelWEB

It is impossible to give clients absolute certainty about their retirement income, but setting policies ahead of time can manage the risk, according to Michael Kitces, partner and head of research, Pinnacle Advisory.

“I can’t quite give you certainty…but we can articulate what the actual plan is going to be.

“It becomes a means of dealing with what otherwise is the uncertainty that we all struggle with in getting people through retirement,” Kitces, from Washington,DC, said during a presentation at the PortfolioConstruction Forum Conference in Sydney last week.

“We find that for advisers that do this with clients, it’s hugely relieving when they’re going through times of market volatility, because that’s the challenge that most people have, particularly retirees, during volatile markets,” he said.

Sequencing of return risk is one of the broadest categories of risk facing retirees. According to Kitces, when market volatility persists for only one to two years, a more passive approach will usually suffice.

“What we’re really trying to deal with is not just things like ‘what happens if I retire on the eve of the Global Financial Crisis or the tech wreck’ but ‘what happens if I retire on the eve of a terrible decade?’” he said.

“We can get creative about how to manage volatility for a year or two, we can put cash aside…[but] bad decades are harder to dodge, you can’t really hide.”

Kitces suggested financial advisers should establish a policy document – similar to an investment policy statement – that sets out clear parameters for how a retirement portfolio will be managed in the future.

“Just as many of us look at doing things like investment policy statements with clients…now we see the emergence of withdrawal policy statements around retirement.

Passivity is no help

“Most of the time, we end up telling clients ‘don’t’ worry, sit tight, stay the course, stay invested, we’ll recover.

“But it’s not actually very reassuring to tell people ‘basically, my plan no matter what happens is to sit tight,” Kitces said.

He believes a large part of the problem is that clients often don’t know where the tipping point is, and advisers are usually not very good at telling them.

“Except the problem is that at some level, they all know eventually things will actually be so bad, that it doesn’t matter if [markets] recover, because they’re going to run out of money,” Kitces said.

A three-tiered approach

Three of the most common methods advisers use to minimise sequencing risk are the safe withdrawal rate approach, dynamic asset allocation and dynamic spending strategies.

The safe withdrawal rate approach has been popular in the United States for a number of years. “We look back on what the sequence of spending was, we look back on what the sequence of returns was,” Kitces said.

He referred to data that shows when the good years and bad years are averaged out, the safe withdrawal rate is around 4 per cent.

Using Australian data spanning the period between the early 1900s and the 1970s, the figure is also around 3.5 to 4 per cent.

“It’s not even just about bad sequences of market returns in nominal dollars, but bad sequences in real dollars. Inflation spikes are actually particularly damaging for retirees,” Kitces said.

Asset allocation strategies are often described as bucket strategies and partial annuitisation strategies and different ways to dynamically adjust allocation. “All of which support higher sustainable spending in some way, shape or form to deal with sequence risk”

Bucket strategies means dividing spending segments into short-term, mid-term and longer-term classes, ranging from one to three years, four to eight years and 10 or more years.

Dynamic spending strategies, or ratcheting strategies, involve starting with a  very conservative spending rate, which is then reassessed every one or two years against market performance. If markets start growing, spending can be ratcheted higher.

“But because we don’t know whether we’re going to get the good sequence or bad sequence, valuation is some prediction, we’re going to simply start you at a conservative number and ratchet you higher as we go.

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TOPICS:  Michael KitcesPinnacle Advisory GroupPortfolioConstruction Forum



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Glenn Freeman

About The Author /

Glenn Freeman is a senior journalist for Professional Planner. He has around three years’ experience in financial services journalism, having also covered broader areas of business including M&A activity and energy. His journalistic experience includes five years spent abroad, where he was editor of an oil and gas title in the United Arab Emirates along with other in-house and freelance projects, which included stints in motorcycle and automotive journalism.