What Is the ‘Retirement Risk Zone?’

On this episode of The Long View, Wade Pfau, author, founder, and retirement researcher, discusses the best spending strategies for retirees, ways to mitigate sequence risk, asset allocation, and lessons from the third edition of his book, Retirement Planning Guidebook.

Here are a few excerpts from Pfau’s conversation with Morningstar’s Christine Benz and Amy Arnott.

The ‘Retirement Risk Zone’

Christine Benz: You recently co-authored a paper with Michael Finke and David Blanchett, both of whom we’ve mentioned throughout this conversation about what you call the retirement risk zone. And it sounds like it’s the 10 years surrounding someone’s retirement date—before retirement and then just after retirement. Can you talk about why that is such a dangerous time, and what preretirees can do to defend against it?

Wade Pfau: Yeah. So it’s lifetime sequence-of-returns risks. The sequence-of-returns risk idea comes up in the retirement context with the idea that, if you’re trying to meet a fixed spending goal in retirement, if there’s a market downturn early in retirement, that can dig a hole for your portfolio in a way that a market downturn later in retirement may have very little impact because you’ve already kind of figured out by that point whether you can spend a lot or a little. And that exists preretirement as well. So when people are saving for retirement, there is sequence risk. If I just invest money in year one and leave it alone for the next 30 to 60 years, there’s no sequence risk. I’d always have the same balance at the end.

But whenever there’s cash flows, there is sequence risk. So if I’m saving a percentage of my salary for the next 30 years, market returns early on have very little impact because I haven’t saved anything yet, but by those final years before retirement, those market returns impact all my years of contributions. And so the market returns in the years just before I retire matter quite a bit and, arguably, depending on how you frame the problem, just as much or more than the market returns in those early years after retirement. So you get this zone where, in the years before retirement and the years after retirement, if you experience a market downturn at that point, that can really disrupt your retirement plan. If you just think about the logic of like, well, if you assume a 7% rate of return every 10 years, your wealth doubles, well, that means when you’re 10 years before retirement, if you’re assuming that, you’re only halfway to your retirement goal and you’re really vulnerable to what specifically is going to happen in those 10 years leading up to retirement.

So you do get that sort of sequence-of-returns risk, both in the preretirement phase and the postretirement phase. And so in terms of what people can do about that, well, part of that is just the whole idea of target-date funds, the idea that you start to take some of that risk off the table as you get closer to the target date, that can help manage the risk. And then in the context of retirement-income styles, part of the idea, too, is in the five to 10 years before you retire, if you have a different retirement-income style, so if you’re time-segmentation, it’s, instead of continuing to invest in bond funds, I’m going to start layering in, say, 10 years before retirement, I’ll buy a 10-year bond, then one year later, I’ll buy another 10-year bond, and then I’ll get to retirement with the next 10 years of income in place, that can be a powerful way to manage the risk.

And then if you’re instead more of a income-protection or risk-wrap style, it’s allocating some of those bonds to annuities with lifetime-income protections to take that risk off the table for those assets. It’s about transitioning, really, your bond holdings into something better designed for your retirement-income portfolio in those years leading up to retirement. I think that’s the most powerful way to manage the sequence risk, to take risk off the table when you’re the most vulnerable to market volatility having a negative impact on your financial plan.

Retirees and Preretirees: It’s Not Too Late to Derisk Your Portfolio

The Biggest Risk for New Retirees

Managing Sequence-of-Returns Risk With a Rising Equity Glide Path

Amy Arnott: You’ve also done a lot of research on an equity glide path that actually increases during retirement after you’re out of that danger zone five years after retirement. How would a system like that work in practice?

Pfau: Yeah. That rising equity glide path idea, that was research I did with Michael Kitces, and with that, that could be a total-return implementation of the idea of taking some of the risk off the table. So with target-date funds, you become less aggressive as you get closer to retirement. And the issue with target-date funds is: It would be rare to find a target-date fund that’s at least 50% stocks at the target date, but there’s a whole parallel research with the work Bill Bengen did on the 4% rule. His 1994 original article said retirees should be as close to 75% stocks as possible and in no circumstances less than 50% stocks. And that result holds up whenever you look at data either in Monte Carlo simulations or historical data, it usually calls for aggressive asset allocations, but that exists in a separate world from what target-date funds are doing. And with target-date funds, it’s usually you get a low stock allocation at retirement and then you either keep it low or you continue to make it even lower.

And so what Michael Kitces and I were looking at was, just as a risk management technique, really what you can be doing post target date is working your way back up. And so as a case study in our research, we looked at, well, instead of holding a 60/40 portfolio throughout retirement, using that kind of logic of the 4% rule idea, what if you started at 30% stocks, but then worked your way back up to 60% stocks over time? And that worked as a risk management technique that helped reduce the vulnerability to what’s really the worst … Well, the true worst-case scenario in retirement is you get bad market returns for like the next 30 years. You can’t really plan for that. The more practical worst-case scenario in retirement is you get a market downturn in the early retirement years but eventually markets recover, and so using a rising equity glide path helps manage the risk around a market downturn early retirement with then subsequently markets recover.

And so we hear from folks, it resonates with some people, but it doesn’t resonate with others. I don’t really push it as this is something anyone in particular should be using, but if it resonates with you, yeah, the evidence is in favor of, it works as a risk management strategy in retirement, and it’s something for the total-returns investor who’s actually changing the stock allocation in their portfolio every year. But the original genesis of this was naturally if you have like Social Security or if you have annuities or if you have a pension, if you look at the present value of those assets as part of your bond holdings, then as you age, the present value of your pension or annuity sources or Social Security declines with age and, therefore, from a total household perspective, you might have a rising equity glide path even if you’re not changing the stock allocation of your investment portfolio. If you treat the present value of your fixed-income payments as part of your bond holdings, you naturally get a rising equity glide path in retirement.

So in that regard, a lot of people, anyone who has Social Security and keeps a fixed stock allocation in their portfolio in retirement, as long as their portfolio is not declining too quickly, which is rare for people using conservative spending strategies, you might have a rising equity glide path without even really recognizing it. The issue is you specifically want to use a rising equity glide path by changing your stock allocation every year, and that’s where, yeah, it can work as a risk management strategy, but if that sounds like a terrible idea, don’t do it. It’s not necessary. It’s just an option out there to help manage sequence-of-returns risk in retirement.

How to Mitigate Market Risk When Delaying Social Security

Benz: Yeah. Sticking with sequence-of-returns risk, I wanted to ask about people who have taken to heart the advice to delay Social Security in order to enlarge their eventual benefit. Can you talk about the risks for them? If a bad market environment happens to materialize and they haven’t purchased any other guaranteed income, they haven’t sunk money into an annuity, and so they’re taking larger withdrawals from their portfolio in those early years of retirement, and that portfolio is simultaneously declining. Can you talk about the risk for people who are thinking about a strategy like that?

Pfau: Yeah. I walked through a case study about this in the Retirement Planning Guidebook, the chapter on Social Security, because it is a really important point. If you’re 62 and retired and you decide to delay Social Security to 70, you have to take a bigger distribution for the next eight years with the idea that you can then take a smaller distribution after that. And if you’re taking that distribution from your total-return investing portfolio, that absolutely increases your sequence-of-returns risk.

But this is not an argument against delaying Social Security. This is where you need to use a Social Security delay bridge. You need to build something so that you can replace that missing Social Security benefit with some sort of resource that’s not exposed to the market volatility, so that you don’t increase your sequence-of-returns risk. And I walked through a case study about, you could carve out an eight-year TIPS ladder where you have inflation-protected bonds to cover your missing age 70 Social Security benefit for the next eight years, carve that out of your portfolio entirely and, because the delay credits from Social Security are so powerful, you now have 77% more inflation-adjusted spending from your TIPS ladder and Social Security and, to meet your additional expenses on top of that, you can use a lower withdrawal rate from the remaining investment portfolio outside of what you carved out.

Retirees: Take the Risk Out of Your Income With a TIPS Ladder

You actually can lower the withdrawal rate, and with the whole discussion about safe withdrawal rates in retirement, being able to meet your spending goal with more reliable inflation-adjusted lifetime income and with using a lower withdrawal rate for the discretionary piece, that reduces risk for the financial plan. That puts you on a course for a stronger, either more legacy at the end of retirement, or you could spend more throughout retirement, or you just have a lower risk of depleting your asset base in retirement with more reliable income if you do deplete your asset base in retirement. So you build a Social Security delay bridge if you’re delaying Social Security, you don’t leave that exposed to the market. I talked about carving out a TIPS slider to do that.

There are other options, too. Just if you are doing part-time work, that could be an option. Reverse mortgages is an interesting potential way to build a Social Security delay bridge through the value of your housing wealth. You could get a period-certain annuity that just pays for those eight years if you’re delaying from 62 to 70. There’s a lot of different options out there, but it is very important that you build a Social Security delay bridge if you’re retired already and are delaying your Social Security benefits.

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