You’ve worked hard your whole life, saving along the way for a retirement that’s now upon you. You’re finally ready to transition to a new lifestyle of relaxation and enjoying the things you’ve long dreamt of but never had the time for: traveling, reconnecting with old friends and spending more time with the grandkids, to name a few.
But how realistic is this dream retirement if your portfolio has to contend with a market decline? Or if a longer-than-expected retirement puts you at risk of running out of money later in life? Fortunately, there are ways to help you prepare for these unknowns.
Sequence-of-Returns Risk
The closer to retirement, the more vulnerable you are to adverse market conditions. That’s because you have less time to recover from such setbacks. One of the greatest risks for retirees is what’s called sequence-of-returns risk, which is the risk of experiencing poor market performance right before or early in retirement, when your portfolio is likely to be its largest.
“A bad sequence of returns in your portfolio during this critical period may force you into having to spend less to avoid depleting your nest egg too quickly,” explains Joe Toledano, Managing Director, Head of Insured Solutions, Morgan Stanley Wealth Management.
Here’s one such scenario: Let’s say a new retiree with a $1 million portfolio plans to withdraw 4%, or $40,000, in her first year of retirement. If a market downturn causes her portfolio to suddenly decline 30% to a value of $700,000, that original $40,000 withdrawal now accounts for 5.7% of the portfolio’s value. Such a higher withdrawal rate may not be sustainable long term without a rapid recovery in her portfolio’s value. What’s more, withdrawing funds during this hypothetical bear market lowers her portfolio’s base of assets, increasing the returns that would be required for it to recover.
Longevity Risk
Equally worrisome for many retirees is the prospect of running out of money. This is a growing concern as medical advances and improving public health drive greater longevity.1
Consider the retiree who, at age 65, has a $1 million portfolio with 60% in stocks and 40% in bonds. Based on Morgan Stanley Wealth Management’s capital market assumptions, she would have a high, 93% likelihood of being able to sustain 5% withdrawals from her initial portfolio each year, indexed to inflation, if she lives to the average life expectancy of 85.2 However, if she were to live another five years, the likelihood of being able to keep up that income level falls to 74%, exposing her to material risk of running out of money.2
What’s more, if she enters retirement a bit less prepared and therefore has to spend 6% of her portfolio in her first year, her probability of making it through retirement without exhausting her savings drops from a less-than-ideal 70%, to a likely unacceptable 41%.2
It’s little surprise then that 57% of pre-retirement Americans say they’re concerned about the loss of regular paychecks in retirement, with nearly a quarter claiming they are “terrified” by the prospect.3 This fear may drive some retirees to actually under-spend relative to what they can afford, sacrificing their standard of living.
Retirement Income Conundrum
How can today’s retirees help minimize these risks?
For most Americans, gone are the days of a traditional pension plan that provides a steady, guaranteed income stream in retirement. In 2023, only 15% of individuals in the private sector had access to such defined-benefit pension plans.4
“Traditionally, bond yields also provided some sense of security,” notes Carmine Mazzeo, Executive Director, Insured Solutions, Morgan Stanley Wealth Management. “But even with interest rates near their highest levels in two decades, they still may not be enough to support the income clients need to cover expenses in retirement.”
How Do Annuities Work When You Retire?
Annuities may offer a potential solution to such challenges. For one, they can help to mitigate sequence risk by providing a reliable source of income that can reduce—and, in some cases, may even help to eliminate—the need to sell portfolio assets with high return potential at a moment when asset prices have fallen precipitously.
Additionally, annuities with guaranteed income-protection benefits provide a set level of income for the rest of your life, much like a traditional pension in that respect. By adding such annuities to your portfolio, you may potentially reduce the risks that poor judgment, declining markets or a longer life expectancy will jeopardize your ability to live comfortably in retirement.
In fact, a 10-year analysis by Morgan Stanley’s Global Investment Office found that annuity allocations in a portfolio enhanced outcomes for savers in a remarkable 97% of cases, relative to strategies using only traditional investments with the same level of risk.2 The hypothetical portfolios with annuity allocations delivered:
- 19% higher probability of sustaining income throughout retirement, on average2
- 10.1%-11.8% higher wealth after sustaining 30 years of withdrawals2
Another potential benefit of annuities: Unlike with traditional investments, the earnings and interest associated with an annuity are not subject to taxation until paid out, even when they are held within a taxable investment account.
“Annuities are a tool that, when used intelligently, hold immense potential to improve an investor’s quality of life in retirement,” notes Dan Hunt, Morgan Stanley Wealth Management Senior Investment Strategist. “They can successfully reduce risk in a retirement plan because their payout rates are typically higher than the yields on traditional investments and they remain viable regardless of one’s longevity.”
Do You Have a Strategy?
Annuities come in many forms, including variable, fixed and fixed indexed, with a variety of features and price points. However, retirees are often unsure how to incorporate them into a comprehensive retirement strategy.
A financial advisor can help you not only evaluate and secure the appropriate annuity options from the most trusted and highest-rated issuers, but also develop investment and systematic withdrawal strategies based on your unique circumstances.