Will my income last a lifetime?

When it comes to planning for retirement, all investors can agree on one thing: save early and save often. But as the Baby Boomer generation has started to retire, the topic of decumulation, or spending down one’s retirement assets, is gaining prominence – and it’s far from a straightforward exercise.

When it comes to planning for retirement, all investors can agree on one thing: save early and save often. After all, accumulating a retirement portfolio through good long-term investing habits can allow you to enjoy a great deal of financial flexibility in your post-working years.

However, over the past 10 years, as the Baby Boomer generation has started to retire, the topic of decumulation, or spending down one’s retirement assets, has gained more prominence. With 10,000 individuals in the U.S. turning 65 each day, decumulation is likely to remain an important topic for many years to come. Unfortunately, it can be far from a straightforward exercise. Investors face competing objectives, including a desire to maximize the income they draw from their portfolio, minimizing the variability of that income from year to year, and ensuring that their portfolio will support their spending needs throughout their lifetime.

What makes it so difficult to achieve these goals simultaneously is that investors in retirement are very susceptible to sequence of returns risk. What does that mean? Simply that retirees decumulating their portfolio may realize different retirement outcomes just due to the sequence in which market returns occur. Said another way, when you retire can be as important as how much you have when you retire.

The examples below illustrate the portfolio value over time of three different hypothetical investments which all had an average annual rate of return of 7%. For an investor in the accumulation phase, all three investments would have ended with the same value, although they experienced different paths to get there, as shown in the first chart. This story changes, however, when an investor enters retirement and begins to decumulate. Portfolio withdrawals compound losses, making it harder to recover from a portfolio decline, especially one that comes early in the sequence. The second chart illustrates the same three portfolios, but we’ve now added $60,000 inflation-adjusted annual withdrawals. Sequencing risk can be biting: while one investor would have run out of money before the end of the 20 years, another would have ended the period with more than her starting assets!

The impact of sequence of returns risk

Return pattern

Source: BlackRock. This graphic looks at the effect the sequence of returns can have on your portfolio value over a long period of time. Other factors that may affect the longevity of assets include the investment mix, taxes and expenses related to investing. This is a hypothetical illustration. The accumulation phase illustration assumes a hypothetical initial portfolio balance of $1,000,000 with no additions or withdrawals and the hypothetical sequence of returns noted in the table. The decumulation phase illustration assumes a hypothetical initial portfolio balance of $1,000,000, annual withdrawals of $60,000 adjusted annually by 3% for inflation and the hypothetical sequence of returns noted in the table. These figures are for illustrative purposes only and do not represent any particular investment, nor do they reflect any investment fees, expenses or taxes. When you are withdrawing money from a portfolio, your results can be affected by the sequence of returns even when average return remains the same, due to the compounding effect on the annual account balances and annual withdrawals.

Unfortunately, as these scenarios illustrate, traditional approaches to decumulation may be ill-equipped to address investors’ most basic needs. In the absence of having perfect clarity on future market returns, running out of money or experiencing significant volatility in yearly income are real possibilities and does not provide retirees with the peace of mind that they deserve.

At BlackRock, we’re tackling the retirement income challenge head on and seeking to deliver more resilient solutions that account for the inevitable uncertainty of markets. In May, our colleague Anne Ackerley spoke about the need to provide more security for 401(k) investors. Now, we have introduced another new retirement income solution that provides a more dynamic and adaptable way to decumulate a retiree’s personal investment portfolio. We focus on three key parameters: a target investment horizon, a target ending value, and a target minimum income distribution. Our goal is to maximize investor cash flow while dynamically adjusting distributions when needed in order to keep the portfolio on track with its objectives. The result? A modern approach to an age-old dilemma and more choice for a generation that has worked so hard to get to this stage in their lives.

Retirement is a hard-earned destination. Spending one’s retirement savings should not be left to chance or simple rules of thumb. The possibility of a prolonged low interest rate environment means retirees face one of the most difficult challenges any generation has had to encounter. Going forward, living off the coupon and dividends of one’s investments is unlikely to generate enough retirement income. A more dynamic and thoughtful approach to decumulation is required— and that approach has finally arrived.