“For retirement income, we must step away from the notion that either investments or insurance alone will best serve retirees. More emphasis is needed on the basic forms of insurance products, and how they may behave as part of an integrated retirement income plan.” – Wade D. Pfau, Ph.D., CFA
Retirement income planning has now emerged as a distinct field in the financial services profession, though it is still in its infant stage and undergoing growing pains. Though not yet recognized by all players, one matter is very clear, and it is that the financial circumstances facing retirees differ dramatically from pre-retirees. For instance, retirees face reduced flexibility to earn income in the labor markets as a way to cushion their standard of living from the impact of poor market returns. Retirees are also seeking specifically to create an income stream from their assets, and this is an important constraint on their investment decisions which was not at the forefront for those still working and accumulating assets.
Retirement income recipients experience heightened vulnerability to sequence of returns risk once they are spending from their investment portfolio: poor returns early in retirement mean that the sustainable withdrawal rate from a portfolio may fall well below what is implied by average portfolio returns over the whole retirement period. One simply cannot approach retirement income planning by using a linear or constant return assumption in a spreadsheet. Though if one does insist on using a constant return assumption to make a retirement plan in a spreadsheet, Pfau (2014) provides guidance on the choice by quantifying how it is important to substantially reduce the return assumption below the expected average, especially in retirement. This is a point which many investment management professionals have not internalized into their thinking, as they are conditioned to using their idea about average returns as the input. These issues suggest that retirees have reduced risk capacity relative to pre-retirees. Their standard of living is more vulnerable to market volatility and extra caution is warranted.
Dr. Wade Pfau discusses the significant risk associated with using the market as your single source of retirement income. Learn simple techniques for maximizing your retirement income in this popular ebook.
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