Weatherproofing Your Wealth Plan

by: Neuberger Berman
Summary

Recent market turbulence is refocusing investors on risk.

After a nearly 10-year bull market, many had become accustomed to regular gains in equity holdings and perhaps gave too little attention to managing downside.

Today's climate, although often anxiety-producing, can also provide a healthy opportunity to reassess portfolios.

In this article, we provide some key ideas to consider in assessing whether your plan is ready for the individual and market storms that may lie ahead.

By Stephen P. Polizzi - Director of Wealth Planning

Is your personal wealth plan able to tolerate the risks that could undermine your financial goals?

Recent market turbulence is refocusing investors on risk. After a nearly 10-year bull market, many had become accustomed to regular gains in equity holdings and perhaps gave too little attention to managing downside. Today's climate, although often anxiety-producing, can also provide a healthy opportunity to reassess portfolios.

Risk, however, is about more than just markets. It also describes personal circumstances that can undermine long-term portfolio growth and hinder your ability to accomplish your goals. So, beyond reviewing specific investment exposures, now may be an excellent time to stress-test your overall wealth plan - to make sure it is well crafted in light of market realities and your personal situation.

In this article, we provide some key ideas to consider in assessing whether your plan is ready for the individual and market storms that may lie ahead.

Pressure Points

First, let's cover some key risks and ideas, which will be important to understand as you assess your portfolio:

Market Return and Volatility: Like the weather, these factors are out of your control. But they can be mitigated through proper diversification, tactical tilts (or temporary marginal portfolio adjustments) where appropriate, and manager selection. Having a realistic "required rate of return" will make any wealth plan more viable.

Inflation: Since the financial crisis, inflation has been quite tame. Even today the Federal Reserve is having trouble hitting its target of 2%. Still, the days of globalization-driven disinflation appear to be over, and there's potential for longer-term acceleration. It would not take 1970s-style double-digit price increases to cut into spending power; even an increase of a percentage point or two could have a major impact.

Longevity: It's odd to think of this as a risk, but with the longer lifespans achieved over the past few decades, it's far more likely that you'll outlast your resources. You'll want to take steps to enjoy the benefits of longevity by limiting your financial vulnerability.

Spending: This is the most impactful-and controllable-risk to your wealth plan. Beyond providing for basic needs, your spending will reflect your priorities as to how you want to live and what you want to accomplish with your savings. You can be aspirational, but you also need to be realistic.

Unexpected Events: The death of a spouse, unemployment, divorce, job loss, a casualty event (like a house fire) and extended illness are among the surprises that potentially could wreak financial havoc.

Sequencing: Bad returns are unpleasant; bad returns at the wrong time can be destructive. If you experience downdrafts early in your career, you have time to recoup. But if it happens when you need income, like in early retirement, the need to draw on depleted capital can undermine growth potential.

Gauging The Viability Of Your Plan

With these risks in mind, you can proceed with your wealth advisor to assess the current health of your plan. Broadly speaking, a wealth plan starts with a comprehensive picture of you as an individual, including your needs and goals, risk tolerance and time horizon. Next is a stage where your advisor will seek to determine an asset allocation that seeks to achieve your goals in light of these personal factors and market dynamics. In this process, it may be useful to apply both a traditional portfolio growth analysis and what's known as a Monte Carlo simulation (or statistical probability analysis) to highlight the investment challenges and opportunities you may face.

Many investors are familiar with the traditional "straight line" approach, which applies the same hypothetical annual return every year, offset by outflows and the impact of inflation. Although this method can capture the long-term negative effects of volatility, it does not pick up the sequencing risk mentioned above, or the potential for returns that are well outside the norm. In contrast, Monte Carlo simulations reflect the unpredictability of markets, and illustrate how investments could fare in a variety of scenarios-exceptional, average and poor-over time.

Typically, this tool will employ capital markets assumptions across a range of asset classes that include return, volatility and correlation. Both views can help you assess the impact of investment risk/return, withdrawals and time horizon on the viability of a hypothetical portfolio relevant to your situation.

Let's run a hypothetical base-case scenario that uses the two approaches, and then compare it to other hypothetical portfolios, stress-tested based on some of the risks noted above.

Hypothetical Scenarios1

John and Jane Moderate, Age 65, 60% Stocks/40% Bonds

In our hypothetical base case, the Moderates are both age 65 with a 30-year life expectancy. They invest $6 million in a portfolio consisting of 60% stocks and 40% bonds, split evenly between taxable investment and tax-deferred retirement accounts. For this purpose, we assume that the portfolio generates a hypothetical blended average annual return of 4.97% annually;2 we assume a $219,000 initial withdrawal rate (including $19,000 to pay ongoing taxes in the investment portfolio), or 3.65% of portfolio value, which is adjusted upward at an inflation rate of 2.25%. Using a straightforward growth analysis (applying the same average return each year), the portfolio's hypothetical value remains fairly stable over the next 30 years, rising gradually and then declining due to withdrawals, to finish at an inflation-adjusted $4.6 million.

Hypothetical Growth of $6 Million: 60/40 Mix Over 30 Years (Average Returns)

Source: eMoney, based on Neuberger Berman inputs.

IMPORTANT: The performance and risk projections/estimates are hypothetical in nature and are based on the assumptions set forth herein. The estimates do not reflect actual investment results and are not guarantees of future results. Results are gross of fees and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Now, let's use Monte Carlo simulation. Its upside scenario, in which virtually everything goes right (the 25th best of 1,000 different randomly sequenced return outcomes), produces rapid growth to generate an end hypothetical portfolio value of $20.9 million, while its median (or middle) scenario results in an end hypothetical value of $5.2 million. (The difference from the straight-line "average" result is due to differences in methodology. See footnote 2 for more details.) However, the downside scenario (worse than 975 other outcomes) reflects the risk present in even moderate asset allocations, with the hypothetical portfolio running out of money around year 22 (reflected in the accompanying chart in a negative result at the end of the entire period). Assuming the couple lives to age 95, the portfolio is a success (avoids running out of money during the hypothetical period)3 in 86% of all conceivable situations.

Hypothetical Growth of $6 million: 60/40 Mix Over 30 Years - Monte Carlo

Source: eMoney, based on Neuberger Berman inputs.

IMPORTANT: The performance and risk projections/estimates are hypothetical in nature and are based on the assumptions set forth herein. The estimates do not reflect actual investment results and are not guarantees of future results. Results are gross of fees and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Stress Test 1: Increased Longevity

Let's change things up to assume (for purposes of illustration) that the couple has a life expectancy of 40 years from retirement, but keep all other assumptions constant. In this case, applying a steady hypothetical 4.97% average annual return, the decline of portfolio value accelerates in later years (in gray), reducing the initial $6 million portfolio to an inflation-adjusted $1.2 million.

Hypothetical Growth of $6 Million: 60/40 Mix Over 40 Years - Average Returns

Source: eMoney, based on Neuberger Berman inputs.

IMPORTANT: The performance and risk projections/estimates are hypothetical in nature and are based on the assumptions set forth herein. The estimates do not reflect actual investment results and are not guarantees of future results. Results are gross of fees and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Running a Monte Carlo analysis provides additional information. In the upside scenario,4 the portfolio benefits from an additional 10 years of growth, increasing to $25.8 million. The median outcome, although it shows some inflation-adjusted deterioration, remains positive. As in the 30-year example, the downside outcome depletes the portfolio around year 22. Importantly, the success rate over the full period declines to just 59%, which is below our 80-85% "confidence zone" for successful plans.

Hypothetical Growth of $6 Million: 60/40 Mix Over 40 Years - Monte Carlo

Source: eMoney, based on Neuberger Berman inputs.

IMPORTANT: The performance and risk projections/estimates are hypothetical in nature and are based on the assumptions set forth herein. The estimates do not reflect actual investment results and are not guarantees of future results. Results are gross of fees and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

What can you do about the longevity issue? One obvious (although not always feasible) option is to save more. In this case, adding another $1 million at age 65 would have brought the Moderates' 40-year success rate up to a more acceptable 80%. A reduction in spending could also be on the table.

However, other ideas may help. One is to seek to generate additional revenue streams later in life, for example with an annuity. Buying an immediate annuity allows you to pay a lump sum and begin receiving regular payments starting the next month; with a deferred annuity, you can "turn on" the annuity payments at a later date (for example, at age 85). The longer you wait, the higher the revenue stream. This feature is available for qualified retirement plan assets using "qualified longevity annuity contracts" (QLACs), although certain limitations apply.5

Typically, deferred annuity contracts say that if you die before the annuity payments start, your heirs will receive some kind of death benefit. However, if you turn on the payments and die shortly thereafter, assuming a single-life payout, the insurance company will keep the balance. It's important to choose the appropriate annuity payout option in light of this risk.

Another idea is the prudent use of equities, which have a higher return profile than most other assets over the long term. Depending on the circumstances, you might marginally increase equity allocations to build capital, and then move gains into fixed income for shorter-term needs, in a practice known as "bucketing."6 High-dividend stocks could be part of the strategy, to combine appreciation potential with income generation. The tradeoff of higher equity exposure is increased risk, as discussed below.

Stress Test 2: Concentration

Next, let's consider the potential impact of concentration risk on portfolios. Assume that, instead of investing in a 60/40 mix of assets, the Moderates go for broke with an all-equity portfolio. Obviously, stocks are the asset class of choice for long-term capital appreciation, but higher volatility (including the potential for major drawdowns) makes exclusive investments in equities inappropriate for short time frames and for highly risk-averse investors generally.

Starting again with $6 million, the Moderates' 100% equity portfolio (using the standard analysis) provides a hypothetical average annual return of 5.96%, fostering steady portfolio growth over 30 years - in contrast to the base case, where the balance is stable but starts to decline after 15 years or so. Using the Monte Carlo, the range of potential outcomes over 30 years is enormous, from a lottery - like upside of $51.2 million to a downside in which the portfolio runs out of money in about 17 years. Overall, the portfolio has an 80% success rate, which is at the bottom range of our 80-85% confidence zone, compared to 86% success in the case of a diversified balanced portfolio of 60/40.

It's important to note that sequencing risk (discussed above) is a particular issue for equities and other higher volatility assets. Leaving all other assumptions in place, let's say that the equity market suffers a major drawdown right before the Moderates' retirement. The combination of a 37% equity decline (the S&P 500's return in 2008) and a 5.24% advance in bonds (the Bloomberg Barclays U.S. Aggregate Bond Index's return in 2008) results in a roughly 21% downdraft for a 60/40 portfolio.

As you would expect, the lower starting point makes it much harder for the portfolios to remain viable in the face of withdrawals and inflation. In our hypothetical average-return analysis, the 60/40 portfolio (dark blue bars in the chart) manages to last 29 years while the all-equity portfolio (in light blue) fails in 25 years. Meanwhile, in the Monte Carlo simulation (not shown), the 60/40 portfolio has a success rate of 50% and the all-equity portfolio just 35%.

Sequencing Risk And Equity Concentration

Hypothetical Portfolio Value after Bear Market Scenario (37% Equity Decline, 5.24% Bond Increase) - Average Returns

Source: eMoney, based on Neuberger Berman inputs.

IMPORTANT: The performance and risk projections/estimates are hypothetical in nature and are based on the assumptions set forth herein. The estimates do not reflect actual investment results and are not guarantees of future results. Results are gross of fees and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

The message here is not to avoid equities, but we do want to reinforce the classic idea of spreading (and thus mitigating) risk within portfolios, and understanding the nature of the assets you hold. Of course, diversification shouldn't stop with equities and fixed income. Equities, bonds, alternative investments and even cash equivalents can help limit volatility, as can diversification within asset classes. Such an approach has the potential to reduce downside while increasing the return potential.

Stress Tests 3 and 4: Withdrawal Rate and Inflation

Among all the factors affecting your long-term well-being, none is more important than your withdrawal rate because it is the most controllable. You will need to think carefully about your spending needs, with the understanding that your interests and priorities may change over time.8 A common rule of thumb is that withdrawals of 4% or less (as in our base case) can provide balanced portfolios with good odds to make it through a 30-year period intact.9 If you increase that rate to 5%, it could cut into principal growth quite quickly. This is reflected in portfolio value over time, both in our average growth and Monte Carlo analyses (see display).

Withdrawals Can Profoundly Affect Outcomes

Hypothetical Growth of $6 Million: 60/40 Mix Over 30 Years - Average Returns

Source: eMoney, based on Neuberger Berman inputs.

IMPORTANT: The performance and risk projections/estimates are hypothetical in nature and are based on the assumptions set forth herein. The estimates do not reflect actual investment results and are not guarantees of future results. Results are gross of fees and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Higher Withdrawals Reduce The Odds Of Portfolio Success

Hypothetical Growth of $6 Million Over 30 Years (5% Withdrawal Rate) - Monte Carlo

Source: eMoney, based on Neuberger Berman inputs.

IMPORTANT: The performance and risk projections/estimates are hypothetical in nature and are based on the assumptions set forth herein. The estimates do not reflect actual investment results and are not guarantees of future results. Results are gross of fees and do not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Although we don't show it here, boosting the assumed inflation rate from 2.25% to 4% also has a very negative impact on the portfolio. While it's true that recent inflation rates have been much lower than long-term historical levels, it is not unrealistic to incorporate 3-4% inflation projections in your planning for worst-case scenarios. Keeping combined inflation and withdrawal rates below your growth rate should allow for potential portfolio growth over time in real terms. But if they are higher than your returns, that will naturally begin eating away at principal and purchasing power.

Addressing Spending And Inflation Pressures

How can you deal with these two issues?

On spending, you need to be realistic about what will be an acceptable lifestyle, but also make a budget and seek to live within your means so you don't needlessly find yourself financially strapped. To keep withdrawal rates manageable, you may want to link some elements of your spending to market performance. For example, in a strong year like 2017 (S&P 500 total returns in excess of 20%), you could withdraw more from equities to pay for a special trip or a major purchase, and then postpone expenses in a weaker year like 2018. Also, keep in mind that spending in the first 10 to 15 years of retirement is generally higher than in later years, except for typically moderate increases in health care costs.10

To help deal with inflationary pressures, you may wish to include exposure to assets that have historically tended to do well in inflationary environments. For example, Treasury-Inflation Protected Securities are indexed to inflation, while real estate and equities generally correlate reasonably well to higher prices. In contrast, traditional Treasuries and other investment-grade fixed income securities are usually more vulnerable to inflation given their sensitivity to rising rates.

Conclusion: Making The Right Moves

Your financial picture is constantly in motion. Market events can have a major influence on whether you are headed in the right direction, but so can unexpected changes in your life. Given your inability to control these forces, it's crucial that you seek to exert control in other ways. Making reasonable assumptions about return potential, understanding your risk tolerance and setting conservative spending targets are among the ways to make your wealth plan more effective and increase your potential for meeting retirement, family and philanthropic goals. Especially in times of market turbulence, having a solid plan can reduce worry about day-to-day price fluctuations, lessen the impulse to make poor choices and help you feel confident about the future.

1 The hypothetical scenarios are for illustrative purposes only and are based upon the following assumptions: initial age of 65, taxable account basis of $2.5 million, application of federal and New York State tax rates; "sunset" of federal tax rates in 2026 to pre-2017 tax reform levels, annual portfolio turnover of 17%. See footnote 2 for return assumptions.
2 For the "average return" scenarios, our growth analysis employs "geometric" average annual returns, which compound annually over the duration of the hypothetical example. In contrast, a Monte Carlo simulation applies "arithmetic" mean returns (in combination with standard deviation, a common risk measure, and correlations between asset classes) around which it develops multiple return scenarios for the first year of the hypothetical. It then generates another set of hypothetical returns for the second year, which it links to the various first-year returns. This process continues until the final year of the simulation, resulting in a typically wide range of performance outcomes. As they incorporate "risk drag," geometric returns are always lower than the corresponding arithmetic returns, which reflect volatility in combination with standard deviation and correlation. In our examples, the asset class return assumptions (Neuberger Berman's return assumptions for 2018) are as follows: equities (geometric): 5.9%; equities (arithmetic): 7.03%; fixed income (geometric): 3.48%; fixed income (arithmetic): 3.54%. The standard deviation for equities is 15.09% and for fixed income is 3.36%.
3 We define success more specifically as the ability to maintain positive portfolio asset value for the duration of the planning analysis. In contrast, a failed trial is any trial run that depletes all of the portfolio assets.
4 The upside scenario provides the 25th best performance out of 1,000 randomly sequenced return outcomes; the downside scenario provides the 25th worst performance out of 1,000 such outcomes.
5 For 2019, the IRS limits premium payments used to purchase a longevity annuity to the lesser of $130,000 or 25% of the participant's account balance on the date of the premium payment.
6 See "Bucketing and Your Retirement Plan," Investment Quarterly, Fall 2017.
7 Bear in mind that this result does not consider the potential recovery of equities after a sharp decline, which could improve portfolio success rates.
8 See "Planning in Stages," Investment Quarterly, Summer 2018.
9 See "Bucketing and Your Retirement Plan," Investment Quarterly, Fall 2017.
10 Source: U.S. Bureau of Labor Statistics.

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