The Largest Risk for Young Retirees

Christine Benz: Hi. I'm Christine Benz from Morningstar, here at the Morningstar conference, and I'm thrilled to be joined by Anne Lester. She's a portfolio manager and head of retirement solutions for J.P. Morgan Asset Management.

Anne, thank you so much for being here.

Lester: Thanks for having me.

Benz: Anne, you took part in a really interesting session today about retirement decumulation. One topic that came up during the course of the conversation was this idea of sequence risk. Let's talk about what that is, and whether that's a particular concern for people who are just embarking on retirement today, given that we're 10 years into a quite strong equity market rally.

Lester: I think one of the things that people really struggle with is, on the one hand, I'm going to live another 30, 35 years that need to be invested, and, on the other hand, what if the market goes down? Sequence of return really is, in our view, the largest risk for the youngest retirees. When your balance is the largest, you've got the most time in front of you. If you have a material 20%, 30%, 40% reduction in your balance, which would mean a really large equity correction, you're risking your ability to generate income in the future if you sell.

A couple of things that I always talk about is being right-risked. Are you at a level of risk where you can tolerate a drawdown in your portfolio and not sell, or only sell little bit to live on? Because, if you don't sell, you're not locking those losses in, and you can recover.

Benz: So the key is to take a look at your asset allocation. How do people sort of right-size their asset allocation just as they're embarking on retirement?

Lester: We actually think that the point in time that you should be the most conservatively invested is actually at that moment of retirement when your balance is the largest. Because that's when your ability to generate returns on that total balance will really, if you have, again, a big drawdown, that's going to really impact your future cash flows. So we really think that sort of on average something sort of between 30% and 40% equity, maybe a little more, is probably appropriate.

Then, oddly, and it's a little counterintuitive for people, as you move through retirement, as you know more about 10 years in, 15 years in, 20 years in, it's sort of counterintuitively a little bit easier to take a little more risk because your balance is smaller. So if there's a drawdown, it's not going to eat away so many years of future income.

Benz: So it's sort of that reverse glide-path idea.

Lester: Right, right.

Benz: The question is, behaviorally, do you have concerns? If someone's managing their glide path on their own, and they've encountered a big equity market shock, and maybe didn't have a very equity-heavy portfolio, so they're OK from a portfolio sustainability standpoint, do you think they'll have the--I guess it depends on the individual--but the mental fortitude to ramp up equity risk at that point?

Lester: Well, even if they don't, it's probably OK. Again, I think one of the interesting things about investing as you're taking money out is that volatility is really not your friend. So sort of the risk of being too conservative, I would argue, is much smaller than it is when you're young, when you can ride through a lot. Because you're systematically assumedly selling, you never have the ability for those assets to go back in.

We talk about dollar-cost ravaging on the way out, instead of dollar-cost averaging on the way in, so it really is a different calculus. Again, if you were going to err on one side or the other, if you are withdrawing, I think it's better to err on the side of being slightly being too conservative rather than slightly too aggressive because your ability to recover is so much more limited.

Benz: I know another thing that you think belongs in the tool kit of retirees is the ability to adjust withdrawals. So rather than just using that 4% with inflation adjustments, static withdrawal amount, you think that taking a look at your withdrawal rate annually and making course corrections is really valuable.

Lester: Absolutely, and from our perspective, it's what people do anyway. I mean, obviously, if your income goes down, if your investments return poorly, you don't take the fancy vacation. Maybe you drive somewhere instead of flying somewhere. Maybe you do a one-week trip instead of a two-week trip. Those are kind of, I think, pretty easy adjustments that, again, if you're reasonably affluent you can make those adjustments. Course correcting to me involves both thinking about how much you're taking, but also, again, that course correction on your risk side. Again, assuming you've got the courage to do it. The market's down, cut what you're taking out a little bit, but also put a little more risk in your portfolio.

Interestingly, we are able to look at data from the J.P. Morgan Chase retail banking network. We get all this data that's fully anonymized, and we do think we have a handle on how America is spending money as they age. We found a couple of really interesting things. The first thing that fascinated us is that spending drops as people age. That's very surprising to some people who think, “Well, surely, healthcare costs will go up, and everything else stays the same, so my total spending will increase.”

What we saw at all wealth levels is that spending drops consistently, really accelerating in people's 80s. If you think about it, you're not going out as much. You're not traveling as much. Your consumption patterns change. So, yes, you're consuming more healthcare, but you're spending less money on everything else.

Benz: So accelerating later in life for healthcare expenditures?

Lester: Absolutely, but never as much as everything else's dropping. Now, surely, some households are different, but, I mean, this is on average.

The second thing that surprised us was sort of, in and around retirement, spending was really volatile. There was a real ramp up, a spending surge as people approached retirement. We think that's people fixing up their houses and fixing up themselves, so maybe getting the knee replaced, maybe doing the operation that they'd been putting off before they retire. Then that spending sort of surge persisted about 18 to 24 months into retirement when spending seemed to stabilize at a slightly lower level. But the spending volatility persisted for a number of years sort of through retirement. To us that really sort of highlighted the need for some flexibility in course correction as well.

Benz: Anne, really interesting research, great to get your perspective. Thank you so much for being here.

Lester: Thank you.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.