When retired clients face a declining stock market and rising inflation, advisers need to go on high alert.
The combination of decreasing account values and increasing distributions spells potential trouble for retirement portfolios. However, not all declines in asset values are problematic and not all increases in the inflation rate are a big challenge. It is the severity of the change that advisers need to assess.
By now, most advisers are familiar with the statistics on historical portfolio failure rates for retirement-income portfolios. Those statistics show that at a 4% inflation-adjusted distribution rate, using a balanced portfolio, the failure rate is close to zero for all 30-year market cycles starting in 1926. But by boosting the distribution rate to 5%, the failure rate jumps to about 30%. That is a helpful statistic, but what advisers really need to understand is what happened during those cycles that caused the portfolios to fail.
‘LETHAL COMBINATION’
While history doesn’t repeat itself, it sometimes rhymes, as Mark Twain is credited with saying. Therefore, studying the factors that were present during the historical cycles that resulted in portfolio failures is a useful endeavor. The most challenging period for retirement-income portfolios was the period between the mid-1960s and mid-1970s. That cycle presented stagnating and declining asset values coupled with rapidly increasing inflation rates.
Some investors might think that the Great Depression would have created the biggest problems. On paper, that is not the case, mainly because the decline was very sharp and occurred over a few years in the early 1930s. Thus, for hypothetical portfolios starting in the mid-1930s, the returns going forward weren’t too bad. Plus, the environment was deflationary, which meant that real distributions were actually falling. The falling distributions reduced the pressure on the portfolios, which resulted in a modest failure rate concentrated around the historical cycles starting in the early 1930s.
But the combination of declining asset values and rising inflation rates in the mid-1960s through the mid-1970s produced a much more challenging environment. Basically, portfolio values were going down while distributions were skyrocketing. This proved to be a lethal combination. For instance, during the 30-year cycle starting in 1966, an initial distribution of 5% would have doubled by 1978 to about 10% of the original portfolio value, as a result of inflation. Unfortunately, the portfolio value would have declined to about 65% of its original value because of the poor stock market returns and the increasing distributions. Thus, by 1978, the distribution in dollar terms was about 15% of the portfolio value. This was clearly an unsustainable situation, and the hypothetical portfolio was depleted by the mid- 1980s.
By reviewing historical cycles, we can get a sense of how the combination of declining asset values and increasing distributions can create big problems for retirees. In short, retirement income portfolios may be able to handle declines of 15% to 20% from their original value (the value on the first day of the investor’s retirement) as long as the distribution remains below 5% of the starting account value. But if the distribution rate increases to 6% as a result of inflation, at the same time the portfolio experiences a 15% to 20% decline, the client’s risk of portfolio failure jumps significantly.
For instance, consider an investor who retired with a $1 million portfolio and an initial distribution of $50,000. Several years into retirement the account value falls to $850,000 because of a bear market, and the distribution needs increase to $60,000 as a result of inflation. At this point, the risk of depleting the portfolio increases significantly. The distribution is now about 7% of the current account value, and it may be difficult to rebuild the portfolio value with such a high distribution rate.
Consequently, advisers who are managing retirement income portfolios should be on the lookout for periods of declining asset values coupled with rising inflation. During such periods, advisers may want to consider counseling their clients to reduce their distributions to preserve capital. If the portfolios can survive the economic storm, they are more likely to experience smooth sailing later on. Getting through that particular cycle with the majority of the portfolio intact will be critical to raising the odds of sustaining the account long term.
While no one knows how the current market cycle will play out, there are some minor storm clouds taking shape in the form of declining asset values and increasing inflation rates.
The stock market is down about 12% to 15% from its October high and inflation clocked in at about 4.1% for 2007, which is the biggest increase since 1990. Both of these trends can possibly reverse. But with a few early warning signs emerging, it may be a prudent time to double-check allocations and distribution rates for retired clients.
