With almost 1,200 Canadians set to retire each day for the next 15 to 20 years, wealth decumulation – rather than wealth accumulation – will become a crucial issue for many clients.
The accumulation phase is all about saving and investment over a defined time horizon; in contrast, the decumulation phase is about withdrawing assets from a retirement portfolio.
This latter phase is characterized by several unknown variables: the life expectancy of your retired client (otherwise referred to as “longevity risk”); the risk of potential market downturns that can erode the client’s capital base; an unknown planning horizon; and inflation and interest rate risk.
Helping your clients deal with those risks can be challenging, especially if the focus of your practice during the past three decades has been on building investment portfolios.
These unknowns have a direct impact on implementing appropriate investment strategies to ensure that your clients do not outlive their retirement savings and have what Matthew Williams, senior vice president and head of defined contribution and retirement at Toronto-based Franklin Templeton Investments Corp., defines as a “sustainable withdrawal rate to ensure a safe passage” through retirement.
“Many [financial] advisors are looking to sharpen their edge in this space; [decumulation] should not be an entirely new concept to them,” says Sam Febbraro, executive vice president, advisor services, with Investment Planning Counsel Inc., and president & CEO of Counsel Portfolio Services Inc. in Mississauga, Ont.
The decumulation phase is a natural part of the financial planning process in which advisors look at the individual situation of each client, says Karl Berger, senior wealth consultant and director with Cidel Asset Management Inc.in Toronto.
Key among the variables that you must focus upon as an advisor is generating a sustainable stream of retirement income to last clients for a lifetime. Unlike in the accumulation phase, during which you typically plan for a known number of years to retirement, the time horizon for retirement income planning is unknown.
“People are underestimating the longevity risk,” says Williams, who believes that most clients need to be prepared for a 30-year retirement.
Planning for income for an unknown period is especially difficult in the current low interest rate environment because traditional income-generating government bonds are posting negative real yields.
“It is difficult to create a fixed-income portfolio to generate income without going outside the risk spectrum” of traditional fixed-income instruments, says Berger.
As a result, greater use has to be made of income-generating equities such as dividend-paying stocks and potentially higher-yielding alternative investments such as real estate, infrastructure and commodities in constructing “a safe portfolio,” says Williams.
However, the use of these types of securities depends on the risk tolerance of clients, says Berger, who believes that a portfolio of high-quality, low-volatility stocks can be used effectively to construct a retirement-income portfolio.
Moreover, greater use of equities and alternative investments can pose additional risk during the decumulation phase because of periodic market volatility, which can result in the permanent loss of capital during retirement.
If clients began withdrawing funds during a market downturn, when the total value of their investments has declined, their portfolios might not recover sufficiently to provide a sustainable stream of income through retirement. This is known as “sequence of return” risk.
Advisors must recognize the cumulative impact of market declines, says Febbraro, and be prepared to make tactical shifts in asset allocation to minimize the risk of losses.
Williams agrees: “Sequencing risk becomes a critical component” of a safe mix of assets.
In addition to personal retirement savings, several other factors must also be considered in decumulation planning.
Among these are government pensions and benefits, including Canada Pension Plan and old-age security, employer pensions, tax-free savings accounts, employment earnings during retirement, inheritance, the potential disposition of property and other non-investment assets, and income from a spouse and/or business.
Also consider the personal and family situation of each client, Febbraro says, including the client’s anticipated lifestyle, potential health-care and unanticipated expenses, the chances of disability, long-term care costs and whether or not the client wishes to leave a legacy.
Once you have taken into account the myriad variables that characterize the decumulation phase, you then must determine a sustainable withdrawal rate to ensure that your client’s retirement funds last a lifetime and meet any unanticipated financial needs.
Both Williams and Berger recommend using the traditional 4% rule (that is, withdraw 4% of retirement assets a year). Berger says this strategy works in the vast majority of cases and is designed to permit withdrawals for 25 years.
The biggest mistake people make, he adds, is to withdraw more than 4% per year. “You can’t ramp up withdrawals in good years,” he cautions.
Williams says the 4% rate is a practical method for decumulation, but advisors need to determine if the mix of assets in a client’s portfolio will support such a withdrawal rate.
This post was first published in InvestmentExecutive.com on August 25, 2016.