Why risks are needed in retirement

Retirees should take investment risks to realize the opportunities of the "three times one-third" rule and achieve their income goals

Andreas Hubener & Thorsten Glemit

Around the world, baby boomers are entering retirement in increasing numbers. As this generation is striving for a more “active” lifestyle during retirement, sustaining a standard of living will be more important, compared with merely covering the base costs of life.

The good news is that about half of the investment returns on a pension pot are able to be generated during retirement, so that these targets can be significantly supported.

Let us consider Robert. He is aged 66 and on the brink of retirement. He has saved 10% of his income since he was 30, which provides him with a retirement nest egg of $225,000. Over the years, he invested this in outcome-oriented solutions that averaged an annual return of 4%. This way, the total investment returns ($111,500) almost match the sum of his contributions ($113,500).

For retirement he schedules a withdrawal plan over his expected remaining lifetime of 21 years (according to mortality tables from the American Society of Actuaries). With the same performance in the decumulation phase as during the accumulation, Robert will gain $110,000 in returns during retirement allowing him to have$12,800 annually with a yearly increase of 2% to adjust for rising costs. At the end of Robert’s life, he will have withdrawn about $335,000. This sum is equally financed by his contributions, the performance during the accumulation phase and investment performance during retirement. This is the “three times one-third” rule, which highlights the equal relevance of all three sources of retirement income.

THREE TIMES ONE-THIRD

A constant return during retirement is, however, unrealistic, as it ignores the investment risk. Riskless returns are well below the assumptions of this example, and Robert has to consider risky assets to receive a comparable income. To determine the best strategy, Robert has to define his investment goals.

Robert is not primarily interested in the return characteristics of the investment. Retirement income and the standard of living it supports is much more important. Robert needs to spend $25,000 annually to cover basic living expenses such as food, medicals and home repairs. As Robert is an active retiree, any additional dollar spent for vacations and entertainment would significantly improve his retirement happiness. Robert would also like to donate to charity, which he would do with any income exceeding $35,000.

Those three goals can be categorized as: basic income, additional “happiness” income and excess income. To find the most fitting investment strategy for his liquid savings, a holistic view of Robert’s financial situation is necessary. Robert receives old-age benefits from social security and a defined benefit pension. These two add up to a riskless retirement income of $20,000 per year. Even though this does not cover his basic income goal completely, it is the corner stone for his old age provision.

Intuitively, Robert should secure the basic income by a completely riskless investment. For financing the additional income, a conservative balanced portfolio of 30% stocks and 70% bonds seems reasonable. Any remaining capital can be invested in return-oriented assets like stocks to generate excess income. Accordingly, Robert would need to invest $105,000 in riskless bonds and the remaining savings in a 30/70 portfolio.

A simulation shows that on average he can achieve $31,400 annual income with this allocation. For this calculation the nominal return of bonds was set to 2%. For stocks, lognormal returns with a mean of 6% and a volatility of 20% were assumed. For the analysis, 100,000 paths that differ in the performance of the stock returns were simulated. In one out of 10 cases, Robert would achieve more than $35,000, thus receiving an excess income.

TAKING SMART RISKS

However, Robert can afford a more opportunistic investment strategy. If he invests all his liquid savings in a 67% stock and 33% bond portfolio, the chance that he would fall short of his basic income goal is still less than 1%. On the other hand, this boosts the expected income to $33,800, a significant increase in his standard of living. Additionally, in more than 40% of cases he has excess income above the $35,000 level.

In reality there are many more asset classes available to achieve the retirement goals. Besides pension income and riskless bonds, inflation protected bonds and traditional annuities help in supplying the basic income. Well suited to increase the additional “happiness” income are dynamically risk-managed investment strategies.

These can help manage the downside risks and help reduce the odds of falling short of the income target, while enabling participation in capital markets to capture risk premiums. As the retiree does not depend on the excess income, he may choose more risky asset-classes and products like stocks, aggressive multi-asset funds or high-yield bonds.

Robert’s example shows that it is not advisable to address these goals independently from one another. Assets targeting additional “happiness” income will not default completely, so they should be used to partially finance the basic income and offer a higher return than conservative products. Likewise, more risky products can also contribute to the second income category.
To realize the opportunities of the “three times one-third” rule, retirees should take a holistic approach in financing their retirement income goals.

Why risks are needed in retirement

Retirees should take investment risks to realize the opportunities of the "three times one-third" rule and achieve their income goals

Andreas Hubener & Thorsten Glemit

Why risks are needed in retirement

Retirees should take investment risks to realize the opportunities of the "three times one-third" rule and achieve their income goals

Andreas Hubener & Thorsten Glemit

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