Timing is everything, so the adage goes, but its impact on retirement can be much greater than people realize. Meet Investor A and Investor B, who were introduced in a recent white paper from Prudential Investments.
In the hypothetical example, each investor begins retirement with $1 million of assets in a balanced portfolio and plans to withdraw $50,000 a year adjusted for 3 percent inflation. They even assume the same cumulative returns over a 30-year period, with an average annual net return of 6.3 percent. So why does Investor A run out of money in Year 16 while Investor B’s portfolio exceeds $2 million in Year 30? The order of their annual returns is completely reversed.
Investor B enjoys positive returns early in retirement. Investor A begins retirement with a streak of negative returns that, despite good performance in some subsequent years, permanently mars his portfolio.
“Whether those negative years happen at the beginning of your retirement or later in retirement will play a really important part in whether you’re able to have that successful outcome and if money you’ve managed to accumulate is going to last a lifetime,” Michael Rosenberg, head of the Investment Only Defined Contribution (IODC) unit at Prudential Investments, tells FA.
According to Rosenberg, sequence of returns risk is the most important risk investors face during what Prudential Investments has coined the “Retirement Red Zone”—the ten years prior to and just after retirement.
This risk can be especially damaging, he says, for individuals forced to retire during a bad market or during a more volatile part of the year as a result of personal health concerns or external events that prompt their employers to rethink staffing levels.
The Retirement Red Zone isn’t the only period when efforts should be made to “de-risk” portfolios. “Risk is something we think about all the time,” says Rosenberg. “There are accumulation risks, there are sequence of return risks as you approach retirement, and there are inflation or purchasing power risks as you enter into retirement.”
Among millennials, who have 30 or more working years ahead of them, “the biggest risk is not being aggressive enough,” he says. According to a Prudential study, more than 40 percent of millennials aren’t saving at all for retirement. If they are saving, millennials also tend to invest too conservatively. Meanwhile, many retirees are ill-prepared for inflation.
“While on the surface it doesn’t seem like inflation has been an issue over the last number of years,” says Rosenberg, “it really is an issue because retirees face a different sort of inflation than do everyday working Americans.” The baskets of goods and services that retirees buy—healthcare, housing and food—have experienced a much higher degree of inflation, he says.
To help investors better manage the triple threat of accumulation risk, sequence of returns risk and inflation risk, Prudential Investments has designed a glide path for its Day One target-date funds that automatically help investors assume what it sees as the proper amounts of risk.
The funds start with a 97 percent allocation to domestic and foreign equities, commodities and real estate. During this early stage of asset accumulation, “we believe you’ve got time on your side and even if there is a downturn or volatility in the markets, time will play in your favor,” says Rosenberg. “We are aggressive for you.”