Advisor Perspectives: “The Four Unique Risks in Decumulation”
Advisor Perspectives, Jan. 3, 2023 — An article by actuary Peter Neuwirth, FSA, FCA, is featured in today’s issue of Advisor Perspectives.
Actuary Peter Neuwirth, FSA, FCA
Relative to the accumulation phase, strategies that mitigate the unique risks faced by retirees in decumulation are less understood and researched. By identifying and illustrating those risks, planners can better prepare clients for retirement.
With tens of millions of Americans retired and as many planning or hoping to retire in the next decade, it is critical for investment advisors and financial planners to communicate clearly with their clients when developing a retirement-income strategy. Specifically, it is vital for both advisor and client to understand the significant differences between planning strategies that are most effective while accumulating assets to be used in retirement and strategies that are most appropriate during the decumulation phase, when drawing down those assets to sustain their cash-flow needs for the rest of their life.
While both aspects of retirement planning focus on ensuring sufficient income during retirement, the decumulation problem is unique.
During the accumulation phase, the individual’s cash flow is positive (e.g., 401(k) deferrals, company contributions, and personal savings); during decumulation, cash flow is negative (e.g. withdrawals from a 401(k), savings accounts and other personal assets like home equity cash value life insurance policies, etc.).
What is less obvious is that the time horizons for accumulation and decumulation differ. While the end point of accumulation (i.e., retirement) is usually within the individual’s control, the end point of decumulation is determined by life contingencies (e.g., death) and variables that are not easily calculable on an individual basis.
Financial risks unique to decumulation
There are six distinct financial risks that retirees face as they try to sustain themselves for the remainder of their lives. Because of the cashflow and time horizon differences just noted, only the first two are present during the accumulation phase.
Specifically, there is a large body of investment theory addressing inflation and investment risk during the accumulation phase, beginning with Harry Markowitz’s modern portfolio theory and the many refinements added in the last few decades.
There is also literature on investment and asset allocation strategies that protect against liquidity risk while accumulating assets to be used in retirement. Investment liquidity risk is distinct and must be considered along with inflation/investment risk during both accumulation and decumulation. It reflects the risk that changing the asset allocation of an investment portfolio could require selling an investment in a down market.
However, once an individual begins decumulating assets (i.e., retires and begins to draw down assets to meet living expenses), they face four more risks that were either non-existent or immaterial while the individual was accumulating.
The four separate risks that are highly significant only during decumulation are:
- Sequence of returns
- Longevity
- Taxes
- Spiking expense
What follows is a brief description of each and commentary on the types of approaches which are effective for mitigating them. Decumulation remains a very hard problem – one with no “closed form” solution and where research has been very limited. It seems unlikely that a comprehensive general strategy can be developed to address all four risks for everyone or even most people who are developing financial plans for their retirement years.
Sequence of returns risk
Sequence of returns risk has been well studied by actuaries and others, but until recently it was not recognized as vitally important in decumulation while being largely immaterial (from a planning perspective) while accumulating assets
Sequence of returns risk applies to retirees whose primary source of income is a securities portfolio – typically, but not necessarily, a 401(k) account or a rollover IRA.
It arises from two factors: 1) The volatility of the securities portfolio from which the retiree is distributing income; and 2) the need to sell some of the securities to meet living expenses when the portfolio is at a low point in its volatility cycle.
Selling low is, of course, the route to premature portfolio exhaustion.
The good news is that research has shown that this risk can be addressed for many retirees with a coordinated drawdown strategy that uses an asset whose return is uncorrelated with the invested portfolio. An example is a home equity conversion mortgage (HECM) that can be drawn on rather than the portfolio when the portfolio is down.
For those interested in the mechanics of how this works, the methodology and its effect on mitigating this risk can be viewed here.
Longevity risk
Longevity risk is theoretically present during the accumulation phase, but, as with sequence of returns, the risk of outliving one’s assets is much more significant during the decumulation phase. Unlike most other retirement risks, longevity risk grows more acute over time as individuals age and stay healthy. Throughout the decumulation phase, longevity risk becomes exponentially more important – especially as the retiree attains an age where expected mortality increases significantly.
This dynamic aspect of longevity risk is rarely addressed, even in the actuarial literature, and most mitigation approaches (e.g., annuitization) tend to be financially inefficient (i.e., too expensive). As a result, a more targeted approach to addressing this risk is needed. Fortunately, some approaches show promise for mitigating longevity risk in a cost-effective manner.
For example, the purchase of a deferred-income annuity (DIA) directly or through a QLAC is one possibility, but the question of when during decumulation to purchase it is tricky. Too early in retirement and the “premium” is too high (from an actuarial perspective) but waiting too long makes the purchase prohibitively expensive relative to the resources that a retiree has.
Maintaining a buffer asset is a potentially more practical alternative. But as with most life contingencies, direct insurance of the risk (i.e., an annuity) is a more efficient means of mitigating it.
For buffer assets, the challenge is to preserve the asset’s value while maintaining a desired standard of living, while the challenge of annuity products is cost and timing of purchase.
Tax risk
Taxes are always an important consideration while assets are accumulated in anticipation of retirement. An immense amount of research has been done on effective tax planning. It is far beyond the scope of this article to discuss the results of that research or the extraordinary complexity and variety of effective tax strategies developed by experts spanning an individual’s complete lifespan and beyond.
When considering the effectiveness of that range of strategies as the tax laws change, let’s reflect again on one of the fundamental differences between decumulation and accumulation. Those in retirement will be receiving cash from either debt they take on (e.g., a reverse mortgage), assets that they have already accumulated (e.g., 401(k) or IRA) or from a third party by contract (e.g., annuity, Social Security, or employer-provided pension). An individual has substantially more variability and less control with respect to their annual tax expense after retirement than before.
Consequently, while tax risk is very much present during the accumulation phase, once an individual stops working and begins decumulating, it becomes more significant and less manageable. It is useful for retirees to consider not just tax planning but “tax-expense risk” mitigation. Annual tax expenses have not been considered as a unique risk during decumulation from an actuarial perspective in the same way that longevity and sequence of returns risk have. Yet, the actuarial perspective is useful here – considering a retiree’s annual tax expense as a random variable subject to uncertain and hard-to-predict factors (e.g., the possibility that future marginal tax rates will change). During the accumulation phase, long-term tax expense will have a major impact on the level and mix of the accumulated assets an individual will retire with; in the decumulation phase, annual tax expenses directly impact both the retiree’s lifestyle and the risk of outliving one’s resources.
There are no “pure insurance” solutions to this problem, but one idea is converting a traditional/rollover IRA into a Roth IRA and treating the up-front cost of conversion as an insurance premium against the future volatility of the tax expenses associated with distributions. Initial research results are promising, but much more work needs to be done before anything definitive can be said.
Spiking expense risk
We come to what is the most important, yet understudied decumulation risk – that a well-designed and executed retirement-income strategy can be completely derailed due to unexpected “spikes” in living expenses while drawing down one’s assets. Mathematically, this risk is equivalent to amplifying sequence of returns risk with two other unfortunate aspects – the incidence, frequency and magnitude of the spikes are subject to variability that is very hard to model, and the aggregate magnitude of the spikes an individual experiences throughout retirement may be significant enough to warrant long-term adjustments to one’s ongoing lifestyle expectations and/or basic drawdown strategy (i.e., how much of an annual draw to take each year)
Each spike risk may need to be addressed separately. For example, getting divorced while retired can create a very significant spike in annual expenses that last for at least a year and possibly longer. This can be addressed via techniques described in the research now available focusing on how to navigate a “silver divorce” (e.g., here), while other spike risks (e.g., needing nursing home care) can be mitigated via specific insurance products or riders on existing policies. There are many other spikes (e.g., a family crisis or the impact of a natural disaster) that are not easily insurable or manageable.
The challenge for planners is to illustrate for their clients the range of possible spikes that might affect them and make sure adequate attention has been paid to each. Since it is impossible to cover all possibilities, the research into risk-mitigation techniques includes reducing annual draws and/or setting aside a “buffer asset” to partially absorb their impact. But, as with tax-expense risk, much work remains.
Concluding thoughts
Decumulation is one of the most important retirement planning challenges facing the clients and advisors who assist them with their financial plans. It is an open research problem for which only partial, incomplete solutions have been developed.
The fundamental nature of decumulation is different from accumulating sufficient assets to provide for a sustainable retirement. While the extensive body of investment and asset-allocation theory developed over the last 50 years is applicable, decumulation is more of a risk management problem where actuarial science should be brought to bear.
At its core, decumulation is an asset-liability and cashflow matching problem governed by random variables from unruly and difficult to determine probability distributions. It will take researchers in both the investment and actuarial professions to make progress.
This challenge and the scope of research on decumulation are significant and the benefits of making progress vitally important to millions of current and future retirees.
Peter J. Neuwirth FSA, FCA, is an actuary specializing in retirement plan issues. He is a 1979 graduate from Harvard College with a BA in mathematics and linguistics. After leaving Harvard, he went to work at Connecticut General Life Insurance, now CIGNA, and for the next 38 years he worked continuously as an actuary holding significant leadership positions at a variety of firms around the country including most of the major consulting firms (Aon, Hewitt Associates, Watson Wyatt, Towers Perrin and finally Towers Watson).