I was recently in a meeting with a pair of clients who had done everything right preparing for the transition to the work-optional phase of life. They had worked hard. They had saved and are now ready to live off their assets and still leave a sizable legacy to their children.
And still, at the end of a meeting where we reviewed all the aspects of their financial future, the husband leaned into us and said:
“It’s weird to think that now I’m going to have to spend this money after all these years.”
He’s not alone.
The transition from a life spent saving and investing to now living off your accumulated portfolio can trip up even the most prepared recent retiree.
After decades of investing and watching your assets grow, many people are naturally uncomfortable with the concept that they will now have to potentially watch those assets decrease over the course of their retirement—even though that is exactly what they were saving for in the first place!
Why do we feel this way?
The simplest answer is loss aversion. Loss aversion is one of the core underpinnings of behavioral finance. Coined in 1979 by psychologists (and in many ways, fathers of modern behavioral economics) Daniel Kahneman and Amos Tversky, loss aversion posits that the “disutility of giving up an object is greater than the utility associated with acquiring it.” In plain English, we feel the pain of a loss much more acutely than the pleasure of a gain. Knowing this about the human psyche, we can quickly realize that watching retirement accounts have decrease in size as the years and decades of retirement continue can be an anxiety-inducing experience.
What, then, is to be done about this? After all, wouldn’t we all like to breathe deep and relax our shoulders after spending most of our adult lives working to secure a prosperous retirement?
The financial planning process we engage in with every new client plays a major role in addressing these concerns. By laying out a precise annual income plan, that shows exactly where distributions will come from, this can help soon-to-be-retirees feel more confident that they won’t outlive their assets. A critical part of this annual income plan is what we at Opus call the Sustainable Income Ratio (SIR), which gives individuals a concrete percentage of how much of their desired retirement income will come from sources they cannot outlive. This includes income sources like social security, pensions, and annuities. Importantly, higher SIRs have two chief advantages for recent retirees. First, if a big chunk of their SIR income comes from qualified annuities, that income will drastically reduce they are required to withdraw from their traditional IRAs upon reaching the Required Minimum Distribution Age (73, at the time of writing this article). Second, having a larger SIR can help buffer the portfolio against sequence of returns risk.
Sequence of returns risk is a fancy way of saying “starting to rely on retirement assets just when the market has a couple of bad years.” When young investors take a hit to their portfolio, they can shake their fists at the heavens and curse their ill fortune, before patiently waiting for the market to rebound. When recent retirees take a hit to their portfolio at the same time that they start withdrawing those assets to support their life, it can significantly reduce the portfolio’s likelihood of lasting until they pass away. By increasing the SIR of any portfolio, we can leave the bulk of the portfolio untouched during a market downturn, allowing time for those assets to recover and support later years in retirement as the cost of living increases.
Other methods for increasing retiree confidence include “income bucketing,” where some percentage of retirement spending is essential (food, housing, medicine), and the rest is discretionary. We have a version of SIR that we call SIRE – Sustainable Income Ratio for Essentials – that serves this purpose. If the basics are taken care of, that can help someone feel more comfortable with continuing to take necessary investment risk to help ensure their portfolio lasts long enough. Another form of bucketing involves putting some portion of your assets designed to fund your next few years of expenses into extremely low-volatility assets, with intermediate and longer-term assets exposed to greater volatility (and therefore greater growth potential). A final option involves a “rules-based” distribution system, that pegs initial portfolio distributions to a percentage rate (say 2%, to be prepared for all but the bleakest market scenarios), and then adjusts it annually for inflation.
All of these can work, but the key thing for retirees is to feel familiar and comfortable with whichever plan works best for them. The benefit of any financial plan isn’t just in asset allocation breakdowns and growth projections. It is in allowing an individual or couple to get to the end of the working phase of life and look forward to their next chapter with anticipation instead of trepidation that they will have to watch their assets dwindle.
Andrew Harvey, CPWA®, AIF®, CPFA™ is the Chief Operating Officer and a Financial Advisor in Opus 111 Group’s Seattle office. He created Opus’ SYFI (Secure Your Financial Independence) Program for young professionals in 2022 and works in Opus’ Retirement Plan Consulting division. In his spare time, he plays the Irish sports of Hurling and Gaelic Football for USGAA side Tacoma Rangers. Andrew lives in Kent, Washington with his wife Lauren and their two cats, Bella and Leeloo.
The information in this article is for educational purposes only and should not be regarded as specific legal, financial, or tax advice.