Overview
With the baby boomer generation rolling into retirement, financial advisors have been faced with increased demand to assist with retirement income planning. As the financial advisory community struggles to address this demand, advisors are realizing that their traditional planning techniques must improve. In this white paper, we analyze the problem of providing a reliable lifetime income. We compare several approaches and demonstrate that risk management is a key element to a successful investor outcome.
For decades, financial advisors have been offering tried-and-true advice: stay invested in the market; continue saving and investing in your portfolio across all market conditions; when the market goes down, ride out the storm—eventually growth will return and the damage to a portfolio will be repaired. We believe this advice was completely correct when baby boomers were in their thirties and forties. However, this approach simply does not work for clients nearing retirement or in retirement. When an individual must use a portfolio to meet current income needs, it is not always possible to “ride out the storm.”
To solve the retirement income problem, we believe a risk management strategy must be included in clients’ portfolios for two main reasons. The first reason is behavioral. During periods of financial crisis, individual investors are inclined to panic. They tend to sell assets after large market declines and move to cash. This hurts long-term returns, as they lock in significant losses. If this were the only problem, financial advisors might be able to address this issue without adopting a risk management strategy. Advisors could focus their efforts on counseling. However, in our opinion, a second reason makes the adoption of a risk management strategy more critical. This is the fact that market declines combine with withdrawals from a portfolio in a truly toxic way. This sequence-of-returns problem mathematically puts portfolios on an inescapable downward trajectory, ultimately resulting in portfolio depletion.
Conversely, the incorporation of a risk management strategy into a portfolio that is used to fund retirement income is likely to actually increase portfolio returns over time, providing investors the potential to draw more reliable lifetime income from their portfolios. By reducing losses during periods of financial turbulence, a portfolio is able to sustain withdrawals and benefit to a larger degree from a market recovery. In this paper, we will provide a clear quantification of this effect.
The approach we will analyze involves combining a portfolio that allocates its largest exposure to stocks and deploys risk management techniques that major financial institutions have used extensively to guard against severe, sustained declines in the market.
Traditionally, fixed income assets have served a dual role in an investor’s portfolio. Fixed income is used to generate income and manage risk. In the 1980s and 1990s, this approach was very successful; however, times have changed. With today’s low interest rate environment, bonds have not adequately fulfilled income-generating needs. As a risk management tool today, bonds are not only less effective but are also likely to produce adverse and unintended results. When interest rates rise from today’s 30-year lows, bonds will likely decline in value. Instead of offsetting stock market declines, they could actually magnify portfolio losses. As Warren Buffett said in his most recent annual report, “Right now bonds should come with a warning label.”
By combining a portfolio risk management strategy with equities, the need for fixed income assets is reduced.
About Milliman Financial Risk Management LLC
Milliman Financial Risk Management LLC is a global leader in financial risk management to the retirement savings industry. Established in 1998, the practice includes over 100 professionals operating from three trading platforms around the world (Chicago, London, and Sydney), and advises over $80 billion in assets (as of September 30, 2013).
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