Why security in retirement is often luck of the draw

Specific returns clients earn on investments right around retirement disproportionately impact their lifetime outcomes

Jan 16, 2015 @ 11:10 am

By Wade Pfau

From a historical perspective, clients seeking to retire at the present time are facing a tough environment. This is a matter I've been working to quantify. We all face an intense vulnerability regarding our lifetime sequence of market returns. The specific returns we earn with our investments in the years around retirement disproportionately impact our lifetime financial outcomes.

For people who otherwise plan and save in the same responsible way, those born at the right time will be fortunate to sustain a high level of spending over their retirements. Others will live and work at times that will result in less fortunate outcomes. Good fortune is derived from experiencing strong market returns in the years around the retirement date, and we have no control over what these returns will be.

How can you help clients better understand whether they are seeking to retire at a good time or a bad time?

I created an index to provide an answer to the question of how much wealth a hypothetical client could expect to have accumulated by saving 15% of salary (invested in a typical target date fund) in the final 30 years of work. Obviously, each client's personal situation will differ from the hypothetical benchmarked individual, but actual client outcomes will at least be correlated with what is happening for the benchmark retiree in the index. It either is or isn't a good time to retire.

(Mary Beth Franklin: Finding solutions to the key challenges of modern retirement)

I calculate the wealth accumulations for benchmark retirees turning 65 in each month going back to January 1950. Wealth accumulations are expressed as a multiple of the final pre-retirement salary. These values range from a high of 18.4 times final salary for a retiree on Sept. 1, 2000, to a low of 5.9 times final salary for a retiree on Aug. 1, 1982. In January 2015, the benchmark retiree would have accumulated 10.7 times salary (i.e., a salary of $100,000 means wealth of $1.07 million). That 2000 retiree was able to accumulate more than three times as much as that 1982 retiree. This is the shocking reality of sequence of returns risk. Today's retiree is in the 45th percentile for these historical outcomes.

Wealth accumulation is only part of the story, as what really matters is the amount of spending which can be sustained by this wealth. To get some idea about this, I prepared a simple annuitization calculation which effectively assumes that the client buys a 30-year TIPS ladder with their retirement funds. This is a baseline, and any effort to spend more would require taking risk with investments, which most clients would certainly do. TIPS are still relatively new in the United States, and the Treasury Department's calculations for the real long-term interest rates extend back only to January 2000. So I calculate the affordability index from this time.

(More: 'Longevity' in annuities could be the big 2015 focus)

Despite saving quite responsibly over a 30-year period, today's benchmark retiree could only safely replace 38.9% of their pre-retirement salary using the accumulated assets in their financial portfolio. This results from the middling wealth accumulations and extremely low interest rates (the long-term real interest rate at the start of January was just 0.64%). Social Security and other pensions would be added on top of this, making the situation less dire. But today's benchmark retiree is looking at a relatively low replacement rate for retirement income.

This replacement rate is down from a high of 105.2% for a retiree at the start of 2000, and it is up slightly from its lowest point of 33.1% for a retiree at the start of 2013.

With moderate wealth accumulations and low interest rates, today is a particularly challenging time to transition into retirement. The benchmark retiree could only safely replace less than 40% of their pre-retirement salary using investment assets. Retiring clients will require help from advisers who understand and can work with the full spectrum of approaches to building a retirement income strategy.

Wade D. Pfau is a professor of retirement income in the Ph.D. program in financial services and retirement planning at the American College in Bryn Mawr, Penn. He is also the director of retirement research for McLean Asset Management and inStream Solutions. He maintains the Retirement Researcher website.


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