A smooth exchange in a relay race is a thing of beauty – the baton passing from hand to hand, runner to runner, in liquid motion. Such a “changeover” represents an enviable model for managing the transition from working and saving (accumulation) to retirement and spending (decumulation). Recent market volatility and rash selling by some investors are evidence of the challenge involved in creating that smooth transition to retirement – and it’s a critical moment in a retiree’s investment journey.
Among the most difficult and consequential changes is the cessation of one’s regular salary. This utterly transforms the vulnerability of the portfolio: income stops; spending continues; recovery from a market decline is harder. It’s no wonder that new retirees experience “hyper risk aversion,” fearing the pain of market losses 10 times more heavily than they had as savers.1
Dangers of an untimely retirement: false starts and sequence risk
Risk aversion for many individuals peaks just prior to the start of retirement, and for good reason. Arguably the first and greatest danger for near-retirees is a bad beginning (just ask a runner). Timing also matters for the onset of retirement. Even one year can make or break success. For instance, identical investors (with identical portfolios), retiring 12 months apart (January 1972 and January 1973), would have had starkly different experiences in retirement – one nearly doubling portfolio assets over a 30-year period, the other exhausting assets just 23 years in (see Figure 1). An unfortunate sequence of returns, especially when a new retiree is coming out of the blocks, can severely hamstring portfolio performance. In some cases it can end the race well before it’s finished.
Dropping the baton: misbehaviors crystalize losses
Clearly a lot rides on avoiding a bad market sequence in the first years of retirement. But investor behavior may matter more. For instance, a rush to “safe haven” assets in the midst of a downturn can cause irredeemable damage. Market losses may put portfolios in a deep hole early in retirement; persistent spending from those assets may slow or stunt recovery. But an errant move to de-risk, or a rush to cash, typically at the worst point in the market’s decline, can crystallize losses, threatening the success of the retirement journey altogether. It’s the equivalent of fumbling the baton outright. Although staying in the race doesn’t guarantee success in down markets, losing precious time leaves little chance to catch up – even over a long retirement journey.
This time was no different: stay the course
Unfortunately, the dash to cash is an investor behavior that seems nearly unavoidable. From the mid-February 2020 high water mark in equities through 27 March, the S&P 500 dropped almost 30%; during the same period, flows to money market funds hit records for three consecutive weeks (increasing cumulatively by over $800 billion) as investors rushed to exit stocks for a presumed “safe haven”.2 This herd-like rush to cash is nothing new, but for those on the cusp of the retirement “changeover,” its timing and the resulting drag on the portfolio could have long-reaching consequences (see Figure 2).
Managing the changeover
PIMCO’s Income to Outcome retirement framework was developed to help advisors and clients better navigate the handoff from accumulation to decumulation. The framework hinges on a dedicated bond portfolio whose potential benefits include the following:
- “Paycheck replacement” – from target date to target maturity3: Many savers have been “defaulted” to target date funds to help manage their savings to an optimal target retirement year. We suggest applying a similar target for the decumulation side. Before retirement, investors would earmark a portion of their current bond allocation to bond ladders (or low volatility bond portfolios) as a buffer to support spending in the first five to 10 years of retirement. These targeted spending vehicles, maturing annually at par in an amount tied to one’s spending for that year, essentially replace the lost paycheck, providing a dedicated and consistent source of retirement cash flows absent default.
- Reduce the drag from spending: By cordoning off and concentrating spending in these bonds designated for “paycheck replacement,” retirees remove some of the spending drag that would otherwise weigh on their equity-oriented growth portfolio, allowing this critical source of long-horizon capital to fully participate in the long arc of the market’s rising tide.
- Diversify and shift your risk tolerance: Research shows that retirees who have high confidence of meeting their goal of consistent near-term cash flows tend to be less vulnerable to periodic market declines and resulting fear-driven behaviors.4 This level of comfort in having achieved their proximate spending goals may provide a kind of “risk buffer”—allowing retirees to better stay the course on their plan, tolerate higher equity allocations in their growth portfolio, and harvest liquidity premiums from longer-horizon investments.
For imminent retirees, getting out of the blocks smoothly is critical. Having an intuitive plan that first solves for spending, and then allows for more long-term risk-taking, may provide the means to finish the race with confidence.
For a deeper dive into issues affecting retirees, read “Sequence Risk and the Decumulation Dilemma.”