The Real Risk in Retirement Savings

March 4, 2015

When people think about the risk in their retirement saving, they usually think about the value of their investments. How many times have you heard people say that they don’t invest in stocks because they think they are too risky for their retirement savings?  Horror stories abound about people who invested all of their savings in internet stocks only to lose two thirds of their savings when the stock bubble popped in 2000.

How will these people ever have enough money to retire if their asset values fall? Well maybe it’s not all about the asset values, but more about how much retirement income those assets can buy. There are two sides to the retirement process: first saving up enough money, and then using that money as an income stream to support yourself once you stop working.

The savings target

Let’s take for example a forty year old person who is seeing their parents struggling with retirement issues and wants to review his own plan. When he started working for a living and getting ready to raise a family fifteen years ago, he wisely started an ambitious retirement savings plan with the goal  of being self-sufficient in his retirement. He knew that buying a financial instrument called an annuity he would be paid a steady monthly income for the rest of his life.

Being an analytical sort he checked current annuity rates in 2000 and at 6.7% he calculated that a cool million dollars would buy him a $67,000 income for life. So over the next forty-years of his working life he set out to save and invest with the goal of accumulating that million dollar account by the time he retired.

How do you think about risk?

Our ambitious saver loses a lot of sleep worrying about his retirement savings plan. When the stock market goes up, he is elated knowing that his goal is coming closer and that he may be able to retire sooner than he expected. When the stock market goes down, he is in deep despair that he will never accumulate enough to retire on. The rise and fall of the value of his investments drives him crazy and he thinks that maybe he should just invest in super safe investments that never change in value. Surely certainty in knowing the value of his savings would be less risky than watching the account value change each month.

But what about his retirement goal?

When our saver started his career his goal was to save enough to provide a retirement income when he retired. His savings goal was to accumulate $1 million to buy a lifetime annuity which would pay him a $67,000 income for life. Over the years, while he has been focusing on his total asset values, another source of risk has been decimating his retirement income. Interest rates and annuity yields have fallen dramatically.

One of the most popular forms of annuities is a multiple year guaranteed annuity. This pays out a guaranteed rate similar to a CD from a bank. In the first five years annuity rates fell from 6.7% to 3.4%. At the lower rate the million dollars would provide only a $34,400 income; a 49% drop. After ten years in 2010 the annuity rate had fallen to 2.7%, a 60% drop. Currently in 2014 the annuity rate is 1.6% meaning that the million dollars would provide an annual income of just $16,000. That’s a 75% decline in his retirement income. Clearly the risk in his retirement savings plan was not just in the asset values, but also in the lifetime income that those assets could buy.

annuity rates

The income risk is real

This example demonstrates that the risk in retirement plans isn’t just in the changing value of accumulated assets. Converting those assets into a stream of income to provide a comfortable and secure retirement has a huge risk. Most investors worry about the fluctuations of their account values without considering the fluctuations in the income stream that their saving can generate. People fear a stock market that can drop 30% in a year, but fail to consider that annuity rates can drop 30% in a year too. The risk is not just in saving enough to retire, but in being able to buy the income you need when you get there.