Mount Everest and the Decumulation Retirement Portfolio
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Towering at 29,031 feet above sea level, Mount Everest is not only the highest peak above sea level on Earth but also one of the deadliest to climb. Hundreds of lives have been claimed by those bold enough to pursue this challenge, with a majority occurring above Camp 4 South Col, often referred to as the “death zone.” Some fail to gather the appropriate provisions to not only scale to the top of the mountain, but also successfully make it back down to the bottom.
The glory, prestige, and self-accomplishment of making it to the top, compounded by harsh conditions, has blinded individuals from making sound choices in this high-stress situation, which can unfortunately result in tragedy, injury, and even death.
In many ways, the journey involved with reaching the summit of Mount Everest parallels the journey to a secure retirement. First, both require thorough preparation for and familiarity with the challenges of the physical or financial environment ahead. Secondly, resources must be efficiently allocated to reach the peak, while keeping in mind those same resources must last through the descent or later half of the journey. Finally, there is always the possibility of a storm, but you can navigate to a safer place that’s less exposed to heightened risks by bringing along a trusted guide. While the retirement journey may be less treacherous and may not mean life or death, it also comes with its own unique risks, challenges, and obstacles.
The “retirement death zone”
Similar to climbing Mount Everest, many of the risks along the retirement journey become amplified near the peak of the retirement mountain. We often refer to the time zone from three to five years pre-retirement and three to five years post-retirement as the “retirement death zone.” This zone is where stock market losses, sequence of returns risk, improper asset allocation, misguided social security timing, taxes, and other risks are at their greatest.
According to the Alliance for Lifetime Income, this year marks the beginning of the “Peak 65 Zone” with 4.1 million Americans turning age 65 per year. That’s approximately 11,200 baby boomers hitting the standard retirement age per day. These individuals face tough choices during this period of rising uncertainty. The world has seen a lot over the last four years – a global pandemic, historically low interest rates, supply shocks, historically high inflation, one of the fastest Fed tightening cycles since the early 1980s, and rising geopolitical risks.
As a historic number of Americans near retirement, they must be familiar with their financial landscape so they can plan accordingly. Currently, we are experiencing heavy disparities between stock and bond returns. This poses a threat to retirees because over an extended period of time, those who are unknowingly over-allocated to stocks could expose their retirement portfolios to higher downside risk while they are traversing through the “retirement death zone.”
From April 1, 2020, to April 1, 2024, the S&P 500 Total Return was up an astonishing 105.61 percent with a 19.31 percent annualized return. During the same period, the US Bond market was down -20.86 percent with a -5.57 percent annualized return, mainly due to the rapid rise of interest rates from historic lows created by the COVID pandemic. Looking back over the last 20 years, the return disparity between US stocks and bonds is also quite drastic, with a 9.91 percent annualized stock return and a 2.82 percent annualized bond return.
According to State Street Global Advisors:
Long-term investors’ aggregate allocation to fixed income, relative to equities, has not been this unbalanced since before the global financial crisis (GFC). Some of this relates to price effects; the recent dramatic outperformance of equities has pushed equity allocations within a whisker of a 15-year high. Fixed income holdings have gone in the opposite direction and are now, in aggregate, at their lowest level since the GFC.1(Img. 2)
Stock market concentration has intensified
In addition to the historically elevated investor allocation to equities over fixed income, stock market indices have become more concentrated in a handful or two of stocks, creating an environment where indexed investors are significantly less diversified than in years past and higher than it was prior to the dot-com bust. While these particular stocks have experienced significant growth over recent years, they also have lofty valuations and elevated expectations for continued advancement.
The current top 10 appreciated significantly as a result of a variety of fundamental factors. The first catalyst was the rush to well-known, high-quality firms for stable earnings with strong cash flows during the pandemic. The rise of the Magnificent Seven, driven by the fervor around Artificial Intelligence (AI) and how those firms used AI to boost their long-term top-and bottom-line growth, has continued to propel market concentration.2
State Street Global Advisors provides recent research explaining, “Ten firms making up 30% of the total S&P 500 Index market capitalization didn’t happen overnight,” as seen in image 3 below. Expanding on this, they go on to say, “The current firms in today’s top 10 have, on average, been in the top 10 for 92 consecutive months — far longer than the average 68 consecutive month run for historical top 10s.”3
Under significant stress and tight timelines, pre- and post-retirees have to make crucial decisions that may impact their ability to satisfy their income needs for the remainder of their life. Knowing the environment on the road ahead is unfolding from an historically unbalanced market with concentrated stock market indices, the act of rebalancing could provide a solution that provides more preparation in an unpredictable environment.
While rebalancing is a common strategy to bring retirement portfolios in better balance with risk profiles, it is not automatic within most 401k plans unless the employee initiates the ongoing rebalancing. The wide gap between stock and bond returns over an extended period, plus the lack of rebalancing can create situations for pre- and post-retirees where one false step isn’t fatal, but significantly impacts the back half of their retirement voyage.
Putting this all together, older employees nearing retirement and those who recently entered may be facing a scenario where they are both overly allocated in stocks with an abnormally low level of diversification on top of historically high valuations. It is often difficult for workers or retirees to view this as a substantial problem, given it’s gotten them where they are today.
However, decumulation stage rules often shift from rules we learned during the accumulation stage when volatility could be our friend and market dips created buying opportunities. Stock market losses coupled with account withdrawals during the decumulation stage can reduce retirement success probabilities, especially during deep corrections. These potential risks underscore the need for a strategic approach to resource allocation so it’s possible to make it to retirement, but also to thrive in the second half of the journey.
Asset allocations matter for retirement
Let’s evaluate the impact of asset allocation on retirement success in this environment on a deeper level by exploring a retirement scenario for a 67-year-old couple just entering retirement. First, let’s think about this from the hypothetical couple’s perspective. They did it. They reached the top of their retirement mountain unscathed, exhausted but ready to begin their descent.
They want to enjoy the activities and hobbies they either put off or didn’t have time for during their working years. They want to spend their time making lasting memories with their friends, kids, and grandkids. If their health deteriorates in later years of life, they prefer to stay home and receive care instead of moving into a care facility. They worry they may not have enough assets and income to accomplish these goals, and that, at some point, they may be forced to make some tough decisions, and may become a financial burden on those they love.
In this case study, we are going to assume this couple needs $10,000 a month in gross retirement income, has a combined $6,600 a month in social security benefits, $1,000,000 in combined retirement accounts, a three percent inflation rate on income needs and the SSI COLA and a 25-year life expectancy. They plan to withdraw the remaining $3,400 income gap from their $1,000,000 nest egg, representing roughly a four percent withdrawal rate.
For the sake of planning, the base case scenario assumes the $1,000,000 retirement account balance is allocated 60 percent to equities and 40 percent to bonds with a 10 percent standard deviation and no rebalancing. In recent years, much has been written about the ‘death of the 60/40 portfolio’ and the traditional four percent withdrawal rate rule. I believe these fundamental concepts hold a great degree of merit and have the potential to create successful retirement outcomes. However, purely relying upon rates of return and an asset spend down leaves a lot up to chance.
Additionally, this ‘uninsured retirement plan’ may create scenarios where retirees either underspend or overspend, resulting in a significant asset surplus or a more rapid asset spend down. While having a bigger buffer and potential legacy at the bottom of the mountain can sound enticing, consider if it’s worth it to gamble the opportunities to spend quality time and share meaningful experiences with those most important to you. Moreover, think about what it would be like to have diminished supplies during the descent and the anxiety over whether those supplies would be sufficient for the remainder of the expedition.
Incorporating risk management
For comparison, let’s look at what the outcome would be if this couple turns to a retirement guide who equips them with a reallocation and derisking strategy using the pooled risk, longevity insurance, and mortality credits offered by insurance companies. For this strategy, $200,000 of the $400,000 bond allocation moves into an annuity providing immediate joint life guaranteed income (based on the insurance carriers’ claims-paying ability) using an A+ AM Best-rated carrier. From a pricing standpoint, joint life SPIAs with an installment refund and Fixed Indexed Annuities (FIAs) with GMWBs were both considered.
This analysis uses an FIA with a non-performance-based GMWB because it provided roughly $55 per month in a higher guaranteed income payment than the best-priced SPIA. The current pricing on the date this article was written puts annuities at a 7.15 percent level withdrawal rate. With this 7.15 percent rate, the annuity provides a withdrawal rate of $14,300 per year, starting immediately. The age 92 cash flow IRR generated by the $200,000 initial premium is 5.84 percent. More importantly, the remaining $2,208.33 a month income gap is only a 3.3 percent withdrawal rate on the remaining $800,000 retirement account balance, taking less pressure off the investment returns.
There are two schools of thought on what to do with the remaining $800,000 within the retirement accounts. One would be to leave the allocation of $600,000 in equities and $200,000 in bonds, a 75/25 portfolio. Combined with the $200,000 FIA, the retiree maintains a 60/40 stock/fixed income allocation. The second thought is to rebalance the remaining $800,000 60/40 or $480,000 in equities and $320,000 in bonds. Combined with the $200,000 FIA, this rebalanced strategy would carry a 48/52 stock/fixed income allocation.
Spend down bond allocations first?
Without getting deeper than necessary, another option worth mentioning is to spend down bond allocations first and delay equity withdrawals until the bond funds become depleted. Social security timing is another variable to consider as the higher income earning spouse with the higher primary insurance amount could delay social security to age 70 and use the remaining bond funds as a social security bridge. The risk with both strategies is having an older retiree overly concentrated on stocks in the later years of their plan due to the spend down of the bond allocation unless the retirement portfolio is rebalanced throughout the plan.
For this analysis, the current scenario assumes both spouses file for social security at full retirement age and take roughly a four percent withdrawal from the retirement accounts to cover the income gap. The recommended scenario includes reallocating 20 percent ($200,000) from the retirement accounts into the FIA, providing joint life guaranteed immediate income assuming the spouse with the higher PIA delays social security benefits to age 70. The remaining $800,000 of investment accounts maintain a 60/40 stock/bond allocation, and bond funds are not spent down first.
Using a Monte Carlo simulator to compare the outcome of these guided and unguided scenarios, this base case current ‘traditional planning’ scenario has a 61.4 percent success probability. Alternatively, the scenario where they turned to a financial professional to lead the way with an annuity plus partial social security max has a significantly higher success probability at 86.7 percent while also carrying a lower initial stock allocation of 48 percent versus 60 percent.
Notably, while the success probability reduces with a longer life expectancy, the recommended scenario holds up significantly better due to the inclusion of annuity mortality credits and partial social security max. Additionally, a greater percentage of their $10,000 a month income need was covered by protected income sources, allowing most of their essential expenses to be insured while discretionary expenses can be spent from asset withdrawals.
Annuities not without risks
It’s true that annuities can have a bad reputation and are not a one-size-fits-all solution for every situation. The primary risk with an annuity is the reduction in liquidity, which can compound if too large of a percentage of a retiree’s liquid assets are used for guaranteed income planning. Another risk is the insurance carrier going into receivership and the potential for the state guaranty association not to make the client fully whole.
Furthermore, the lifetime income benefits provided by insurance companies favor those with a high probability of living past actuarial life expectancy. For the purpose of illustration, if the case study couple in this article died five years sooner, the cash flow IRR drops from 5.84 percent at age 92 to 4.52 percent at age 87. Essentially, the clients’ health, lifestyle, and family genetics should at least be part of the conversation when considering lifetime income-based annuities.
Lastly, annuities can be overly complex and missold with excessively projected illustrated benefits, often using back-tested index strategies and current cap or participation rates, which may vary over time. Despite these issues, adding an annuity as part of a comprehensive financial plan for a portion of cash, bonds, or other fixed assets – using a highly rated carrier for someone with an above average life expectancy while providing necessary disclosures – can positively impact a retiree’s income plan.
Although annuities may not be for everyone, the current environment could favor many pre- and post-retirees incorporating annuities in their retirement plans. From a timing perspective, annuity income payout rates and benefits correlate closely to new money rates. Generally speaking, we use either the 10-year treasury or the Moody’s AAA Corporate Bond Yield as an indicator for annuity pricing. Both are highly elevated and potentially near the peak of this rate hike cycle.
While nothing is guaranteed, future Fed interest rate reductions could also reduce the annuity income benefits that insurance companies can provide. To put it another way, right now is an exciting time to talk to pre- and post-retirees in the “retirement death zone” about including annuities within their retirement plan.
The importance of meeting retirement objectives
Let’s return to the needs and goals of our hypothetical retiree couple. Not only did they desire $10k a month for retirement, but their retirement purpose was to be able to enjoy the hobbies and activities they put off during their working years and to spend more quality time with friends and family, all while not being a burden to those they care about and not having to worry about running out of money. Stepping outside of the numbers, how does the recommended plan fit the client’s retirement needs and goals? How would this plan impact their lives post-retirement? Would this plan allow them to live more fulfilled lives that better achieve their purpose?
Speaking for myself, answering quantitative questions is generally easier than qualitative ones. I’ll sum it up with a recent article from TIAA:
Money doesn’t always buy happiness, but a steady stream does seem to improve the odds. Ongoing research covering thousands of older Americans shows retirees are happier, healthier, and more satisfied when they have guaranteed monthly paychecks to cover basic needs. They get a happiness dividend, in other words. “Among retirees with similar wealth and health characteristics,” one study concluded, “those with annuitized incomes are happiest.”4
As we’ve seen, the journey of climbing Mount Everest parallels your own personal retirement mountain in many ways. To succeed, you must prepare, and to prepare you must familiarize yourself with the environment and the challenges involved. On both the first and second legs of the journey, resources must be allocated strategically and efficiently to ensure a smooth and stress-free journey from start to finish. Finally, seeking professional guidance to navigate the best route to take can deter you from potentially high-risk storms. Both journeys are hazardous, carry risks and require the proper planning and provisions.
Many prepare for this retirement journey throughout their working lives, either with a guide or on their own. You may decide to go alone and bear the burden of planning for a successful outcome, or you may decide on hiring a retirement guide. Some may fail to gather the appropriate provisions to not only scale to the top of the mountain, but also successfully make it back down to the bottom.
However, there are financial professionals who are well-trained, experienced, and have all the tools and resources to safely lead you to your desired destination. Most importantly, there is someone who cares more about your success than their own and has an unwavering commitment to looking out for your best interests. Lastly, the fulfillment is not in the destination, but the journey. Remember to never lose sight of your priorities, make stops along the way, and enjoy the view from the top.
Brian Manderscheid is an Investment Advisor Representative with LifePro Asset Management located in San Diego, California. He has had an extensive career in the financial services industry and has been analyzing indexed universal life policies and annuities since 2007. Brian is passionate about helping clients achieve their financial goals by using thoughtful, well-balanced strategies involving risk and tax diversification.
Brian can be reached at LifePro Financial Services, Inc., 11512 El Camino Real, Suite 100, San Diego, CA 92130. Telephone: 888-543-3776, x3269. Email: [email protected].
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