Managing risk in retirement portfolios

Portfolio volatility and the sequence in which returns are realized play a unique role in portfolios subject to regular retirement withdrawals. Specifically, volatility affects a portfolio with systematic withdrawals much more negatively than portfolios with systematic contributions. Moreover, negative re-turns early in a withdrawal program can create disastrous initial conditions from which recovery is nearly impossible. Financial advisers can use annuities and other techniques to manage this risk. Consider a client who in December 1999 was looking forward to working on his golf game and traveling during his retirement. Following conservative advice from his adviser, the client figured he could safely draw $40,000 a year from his $1 million nest egg to supplement his Social Security income and allow for inflation-adjusted increases for the next 30 years or so. Being entirely invested in broadly diversified equities, the client was more than a little disappointed that after only three years, his inflation-adjusted withdrawals and the market's ensuing poor performance had eroded his portfolio to less than $538,000. By that time, his withdrawals represented almost 8% of his dwindling portfolio value — a rate that is hardly sustainable. Strong positive returns over the next five years improved matters modestly. But by the end of last year, the client's portfolio had grown only to about $670,000, by which time withdrawals were still 7.3% of the portfolio. Although the client in this scenario is fictitious, his predicament is real.

ALLOCATION SHIFT

Avoiding severe initial negative returns is critical to sustaining withdrawals over long periods. A simple approach to managing this risk is to shift to a more conservative asset allocation as retirement approaches and during those early retirement years. Advisers can return to a more aggressive posture afterward. Contrary to conventional wisdom, retirees can often accept more risk as they age, because the horizon over which withdrawals must be sustained shortens. A related strategy is constructing a laddered portfolio that earmarks specific assets for particular withdrawal years. For example, cash can be used to fund the first three to five years of withdrawals, and intermediate bonds for the next three to five years. The equity portion of the portfolio can be reserved for withdrawals that begin at a later date. The equity portion then has a chance to recover from an early bear market, if it occurs, without being crippled by withdrawals. Like the asset allocation strategy, equity will tend to grow proportionately as the cash and bonds are liquidated early on. However, these strategies don't effectively address longevity risk as do fixed annuities. Including a deferred annuity in the ladder strategy provides a fixed stream of income after a certain point in time — say, 20 years — significantly reducing the amount of precautionary savings necessary to sustain withdrawals over a conservatively long-term horizon. An article in the January/February issue of Financial Analysts Journal shows that deferred annuities are much less expensive than immediate annuities and efficiently transfer longevity risk to insurance companies that can better diversify it.Variable annuities can also manage the problem effectively. Guaranteed-minimum-income benefit riders, for example, give the annuitant the ability to annuitize a guaranteed amount of principal at a specified rate at some future date. If the underlying portfolio suffers from negative returns in early retirement years, the annuitant can still choose to receive a stream of fixed income. This kind of VA protection is like a put option on an equity portfolio and typically costs 0.5 to 0.8 percentage points in extra management fees each year. Unlike a standard put option, its cost is uncertain and spread out over a number of years rather than set at a fixed price today — an arrangement that obscures the price. Equity-linked annuities provide similar protection. Most of the annuity premium is invested in a fixed annuity. The remainder is invested in a series of equity index call options. Like a variable annuity with a guaranteed-minimum-income rider, they are designed to provide potential upside return in exchange for a slightly reduced fixed income. Investors can construct similar results themselves by combining a diversified equity portfolio with an index long-term equity anticipation security put option or by combining a fixed annuity with a Leaps call option. With expirations up to three years, Leaps can protect investors during the critical early years of retirement. This do-it-yourself strategy is often far less costly. Cost is vital. The protections offered by a variable annuity can be eliminated if the cost of acquiring them is too high. As part of their due diligence, advisers need to understand and communicate the material nature of the products they sell and know whether similar products with lower costs, risk or complexity are available in the marketplace. Stephen M Horan is head of private-wealth and investor education at the CFA Institute in Charlottesville, Va.