Why risk management grows more crucial as investors retire

A bear market is no reason for investors in the prime accumulation phase of life to fret. Instead, a drawdown period represents a precious gift, particularly for those in the earlier years of accumulation.

When cash is regularly flowing into an investment portfolio, falling financial asset prices create more attractive entry points that have the net effect of amplifying the portfolio's prospective returns. As a result, younger investors can generally shoulder higher levels of equity market risk, aiming for favorable long-term performance without worrying too much about price volatility along the way. By contrast, investors near or just past the point of retirement don't have that luxury; for them, risk management matters more than ever before.

As a portfolio transitions from the accumulation phase to the distribution phase, the magnitude and timing of market volatility matter much more. Once cash is regularly flowing out of a portfolio, asset price declines have the net effect of muting prospective returns. In fact, severe declines early in retirement can cause permanent principal impairments. As a result, carefully minding the market environment—and explicitly managing the portfolio's sensitivity to it—becomes an indispensable objective for the soon-to-be and newly retired.

Consider two sample return series over a 15-year period. Series one generates an average annualized return of 6% with a standard deviation of approximately 12%, and series two averages a 4% return with a standard deviation of approximately 6%.

In accumulation, series one produces a higher level of wealth than series two. That's true even if the sequence of the sample pattern of annual returns changes. If each series is sorted and the best years are realized first, series ones wins, and if the worst years are realized first, series one still wins—by an even wider margin.

However, the relative advantage of the higher average return in series one doesn't necessarily hold up for portfolios with outflows. In distribution, the sample pattern of returns reveals that the series with the lower average—series two—does slightly better. Moreover, when the worst returns are realized first, series two does far better-and series one fully exhausts the assets in the portfolio before the end of the 15-year horizon-an outcome many would find unacceptable given the nearly three-decade joint life expectancy for a couple retiring at age 65 today. Seeing how losses early in retirement can conspire to deplete a portfolio prematurely, how should investors be positioned for the retirement readiness zone?

The investment approach many institutions take may provide some inspiration to individual investors and advisors positioning a portfolio to support living expenses throughout retirement. A typical endowment manager might have a 5% annual spending target, designed to cover a portion of the university's operating expenses while continuing to grow the principal of the endowment fund in perpetuity. To help achieve this balance, the average university endowment has allocated over 50% of its assets to alternative strategies.¹ An endowment manager's focus is higher risk-adjusted returns-delivering a higher portfolio Sharpe ratio through skill-based trading strategies. Equity long/short funds, for example, use hedges in trying to limit volatility and downside risk while maintaining some exposure to the market's potential upside. An allocation with this type of risk/return profile can play an important role for investors just beginning to take withdrawals from their portfolios.

Finally, the method of withdrawal can have a critical impact on the life of the portfolio and must be part of the allocation decision. While many individual investors would prefer a fixed real, or inflation adjusted, income stream, most endowments use a moving average to calculate the annual spending rate, frequently taking 5% of the average ending value of the endowment over the previous three years. The effect of using this approach transfers some of the volatility risk to the income stream and, consequently, extends the life of the portfolio's principal. Establishing such an expectation at the onset of retirement can make the job of managing a distribution portfolio much easier.

Regardless of the method, we've seen that the stakes are higher when managing a portfolio with systematic outflows. Relative to its accumulation counterpart, a distribution portfolio requires a much different mindset, especially when guarding against large drawdowns in the early retirement years.

1 National Association of College and University of Business Officers, 2016.