Risk management is key to distribution planning

Financial advisers and clients can be their own worst enemies when drafting plans for retirement income, making common — but crucial — errors that can ruin distribution plans, according to an influential academic.

“For many years the retirement industry has been about accumulating, and the main objective has been maximizing alpha,” Moshe A. Milevsky, associate professor of finance at York University in Toronto, said last week at InvestmentNews‘ Retirement Income Summit in New York.

Although the wealth accumulation mindset is giving way to risk management, advisers and clients are hitting bumps in the road that can affect the income distribution plan, he said

Advisers are aware that the sequence of returns during the accumulation phase is irrelevant.

For example, if a client invests $100,000 in a fund, earns 27% in the first year, 7% in the second, and then loses 13% in the third, the end result of $118,000 is identical, regardless of the order of returns.

Investors find this counterintuitive, assuming that “if you lose early on, it’s bad,” Mr. Milevsky said.

During the distribution phase, however, the sequence of returns does matter.

Those who retire during a bear market, for example, may experience a loss of most of their money early in their retirement, Mr. Milevsky said. Comparing a pair of funds with identical growth rates, spending rates and asset allocations, but a different pattern of returns, he concluded that returns and withdrawals during the first five years of retirement are critical and can affect the rest of one’s life.

In short, if the stock market drops early in retirement, there is a much greater chance of financial ruin than if a decline occurs later.

“Stocks can go up in the long run, but in the short run, the sequence of return volatility can ruin your portfolio at high withdrawal rates,” Mr. Milevsky said.

INFLATION A FACTOR

Inflation, another threat to retirees, actually may be more of a problem than advisers and clients realize, he said.

The consumer price index most often cited in the press is a measure based on consumption patterns of wage earners, not retirees, Mr. Milevsky said. The less publicized CPI for elderly people reflects their spending patterns — such as greater outlays for medical care and housing (which includes nursing home and assisted living costs) — and reveals a higher rate of inflation.

Over 25 years, living costs rose 125% for older people, compared with 107% for wage earners.

But inflation and spending will vary for each individual, and advisers should weigh these differences for each client when drafting plans, as opposed to looking at indexes.

“If the Bureau of Labor Statistics created a CPI-E for elderly people, why not a CPI-Me or a CPI-You?” Mr. Milevsky asked.

“The cost of living is personal,” he said. “Your inflation has to meet your distribution rate, not some CPI.”

Mr. Milevsky cited life expectancy and longevity risk as two other unknowns, citing that the survival rate for all cancers has risen dramatically over the past two decades and that more people are reaching their 100th birthday.

He noted that a 65-year-old couple has a 22.1% chance of at least one member surviving until 95.

Advisers reported that clients often can be their own worse enemy when they come in for counseling.

“The biggest thing I run into are retiring clients who are aggressive and want to stay that way. Then there are others who have way too much in cash and fixed income,” said Daniel Geehan, a senior vice president in the private-client group at R.F. Lafferty & Co. Inc. in New York.

“When clients decide to work with me, they are charged with the task of getting out of their way and staying out of my way,” he said.

What clients are experiencing on the ground level often differs from what they are seeing on the news or reading about in the papers, Mr. Geehan said.

“It’s baffling to them when they hear that inflation isn’t that bad,” he said. “They think about how much they pay for milk and gas.”

Advisers’ mind-set of investing for total return as opposed to investing for income is another mistake, said Robert K. Haley, president of Advanced Wealth Management in Portland, Ore. There is always the possibility that a client might need a large lump sum early in retirement in the midst of a bear market, ruining distribution plans, he said.

Showing clients their account balances during the year, along with creating a budget plan for health care, has been helpful in Mr. Haley’s practice, he said.

Other problems among advisers include “projecting accounts will hit zero in 30 years,” he added.

“How is that a long enough time frame [for distribution]?” Mr. Haley asked. “We don’t know the variables — what could happen between now and when the clients die?”

E-mail Darla Mercado at [email protected].

Related Topics: Risk Management