Most people want a long and secure retirement and, to that end, have saved and built up investments over time. But in today’s world, there are threats that can disrupt those retirement savings and diminish their anticipated returns.
- Low interest rates
- Market volatility
- Withdrawal timing and sequence of returns risk
- Government policy uncertainty
- Increasing longevity
“Each one of these challenges can be impactful, especially in terms of the kind of financial behavior they can elicit,” said J. Todd Gentry, a financial professional with Synergy Wealth Solutions in Chesterfield, Missouri. “Without planning and advice on a strategy ahead of time, someone may do damage to themselves that will not be fixable or repairable.”
What follows is a closer look at these areas and possible moves to mitigate them.
Low interest rates
In previous generations, savers could rely on fairly substantial and predictable interest rates to build up their nest egg. Such interest-bearing savings could range from typical bank savings accounts to certificates of deposit to U.S. Treasury bonds. These traditional investments had the added attraction of stability (and still do). And, upon retirement, savers would look to such interest-earning investments to provide income.
That was fine about two decades ago when interest rates were above 4 percent. But interest rates have trended downward, hovering from 1 to 3 percent for the last few years.
This decline is shown in the chart below, tracking interest rates in the United States since 1960, with periods of recession shaded.1
As a result of this downturn, fixed-income investments don’t provide the kind of substantial income stream in retirement that they used to. And the negative consequences could increase further should inflation start to rise.
That’s why many people have turned to market-based investments to provide for retirement income. This has been accelerated by the migration of many retirement savers from things like pension funds to 401(k) plans. (Related: How to win with a steady investment strategy)
Beyond market-based investments, some people have looked to other types of financial instruments, like various types of annuities, to make their holdings less interest rate dependent.
Over time investing in the stock market has proven to be beneficial. Indeed, measures of various equity markets and indexes puts average annual returns between 8 and 10 percent over the past few decades, depending on the particular market and time period.
But it’s not a smooth ride. There are ups and downs behind those averages, often tied to pullbacks in the economy.
The chart below shows historical performance growth in one of the more common stock measures, the S&P 500® Index, since the beginning of 1927 (when the index’s data became formalized and reliable, in the view of today’s market watchers). While the overall trend shows growth, there are substantial pullbacks, particularly during economic recessions (shaded regions).2
Also, some investors look to diversify further into financial vehicles that are insulated from market ups and downs. One example is whole life insurance. Its cash value component can be accessed to supplement retirement income during market downturns. (Related: How life insurance can help you in retirement)
Certain types of annuities can also be used to provide a guaranteed income stream independent of the market.
Market volatility can present challenges for those on the cusp of retirement. A plunge in portfolio value and the resulting decline in returns can crimp what someone was expecting to get in retirement income. Tapping the principal for living expenses can exacerbate the situation further. (Related: Retiring into a bear market)
“Portfolio fluctuations are certainly a concern in retirement,” said Gentry. “The appropriateness of a typical withdrawal rate can be challenged based on economic situations at the time of retirement. It needs to be watched closely.”
The latter point touches on another risk closely tied to market volatility — mistimed withdrawals that end up hurting a retirement portfolio’s overall earnings capability.
Withdrawal timing and sequence of returns risk
Despite market volatility, some portfolios may be large and diversified enough to provide sufficient earnings from year to year. Sometimes though, as mentioned earlier, retirees have a need to tap underlying principal for living expenses — like when a market downturn hampers stock portfolio returns, for example.
The proper withdrawal amount can entail some complicated math, because the need for immediate income must be balanced against the possibility of reducing a portfolio’s future earnings potential. (Related: The ideal retirement portfolio withdrawal rate)
And timing can be especially important in this respect. Experiencing one or two years of negative returns early on in retirement — perhaps because of a sudden market downturn — can have a significant and damaging impact on subsequent returns, a challenge called sequence of returns risk. And, unfortunately, year-to-year returns from a portfolio cannot be predicted. (Related: Beware retirement’s overlooked risk: Sequence of returns)
“Studies now indicate that, upon distribution in a down market, you have a much greater risk of running out of money due to withdrawals and loss of capital simultaneously,” said Jeffrey R. Rotman of Rotman and Associates in Weston, Florida. “There are a few things you can consider to circumvent this, such as purchasing non-correlated assets to the stock market, which you can draw on in a downward trend. Also, there are products such as fixed index annuities that allow you to participate on a portion of the upside of the market, but guarantee all of the principal. A combination of these strategies brings more efficacy to an overall retirement plan.” (Related: Taking cash off the table: Life insurance, annuity alternatives)
Government policy uncertainty: Inflation, Social Security, taxes
Inflation has been relatively tame over the past two decades. However, keeping it contained is by no means a certainty. Indeed, there is constant debate among economists about whether monetary and fiscal actions by central banks and governments aimed at recessions — most recently the COVID-19 pandemic’s economic effects — will result in an inflationary outburst.
Similarly, Social Security, a stable source of income for many retirees, can also be affected by future government actions. There is ongoing debate about how to fund the program, as it is projected to only pay full benefits until 2034. Suggestions include a reduction in benefits paid out or a limitation on who can qualify for Social Security.
And, while taxes are certain, what gets taxed and at what level changes. And in the United States such revisions happen as often as the administration changes. By one estimate, the U.S. tax code has been amended roughly 4,000 times in the last decade.
Changes to any or all three of these areas can affect how much money a retiree can expect.
Longevity and outliving your assets
People today are living longer than previous generations. Indeed, the Social Security Administration calculates that those who reach the standard retirement age of 65 can anticipate living into their eighties.3
“The idea that we are living longer and there will be medical improvements that will cause us to continue to live longer and healthier lifestyles is certainly a positive social outcome,” said Gentry. “That said, the longer we live, the more money we’re going to need to sustain our lifestyles and the longer that will prolong the traditional transition of wealth from one generation to the next.
“In the sense that longevity can amplify all the other risks, I might say that it’s the riskiest risk,” he added.
Increased longevity can present a challenge as it means retirement savings need to last longer. And, more challenging still, they need to last at a level that will generate enough income to maintain a consistent standard of living.
To accomplish that, financial experts generally suggest a retiree would need about 75-80 percent of their preretirement income coming in. To generate that kind of retirement income stream, a retiree would need to have at least 6-8 times their annual salary saved up. And some financial professionals would argue you may need even more, depending on the kind of investments involved and your projected lifestyle. (Related: What’s your retirement plan for living longer?)
A retirement investment portfolio relying only market-based investments may not have enough funds to last forever, especially if funds are drawn from it every year or it suffers from some of the challenges listed above.
To that end, many people look to build a source of retirement income that will be guaranteed well into the future.
Annuities are one option in this regard. They are financial products that generally, in exchange for a lump-sum payment or a series of payments, can provide a guaranteed income stream at some point in the future. (Related: Does an annuity fit your retirement goals?)
Each of these five challenges — low interest rates, market volatility, sequence of returns risk, uncertain government policy, and increasing longevity — can negatively affect retirement savings alone or in tandem with one another. And other unforeseen challenges — a global pandemic, for example — may emerge as well.
That’s why it’s important to diversify not only market-based investments, but also the kind of financial vehicles in a retirement portfolio. Many people opt to consult a financial professional about the choices and what kind of mix may be suitable to help mitigate the risks in their own situation.
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1 International Monetary Fund, Interest Rates, Discount Rate for United States [INTDSRUSM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTDSRUSM193N, March 19, 2021.
2 FRED and Bloomberg as of February 26, 2021. The S&P 500 Index is a market-capitalization-weighted index of 500 of the largest publicly traded companies in the U.S. and is considered a proxy of the U.S. equity market. Past performance is not indicative of future results.
3 Social Security Administration, “Life Expectancy Calculator,” 2020.